September 29, 2014 - Why Do These Fed Decisions Matter?

Markets lost ground last week, though a Friday rally on positive economic data helped trim losses. For the week, the S&P 500 lost 1.37%, the Dow dropped 0.96%, and the Nasdaq fell 1.48%.[1]

Last week, a lot of market focus was on the Fed. Following the Federal Open Market Committee on September 16th -17th, multiple Fed officials gave speeches outlining their opinions about how the Fed should handle raising interest rates and returning to normal monetary operations. Unsurprisingly, there are some definite differences of opinion amongst the Fed's top experts.

The hawks: Monetary hawks generally prefer high interest rates because they fear the effects of high inflation more than they worry about weak economic growth. Prominent members of this camp, like Dallas Fed President Richard Fisher, believe that the Fed should start raising rates as early as Spring 2015.[2]

The doves: Doves tend to favor lower interest rates in order to boost economic growth; they believe that the negative effects of inflation are negligible in comparison with the benefit of increased economic activity. Prominent doves include Chicago Fed President Charles Evans, who favor keeping rates low until they can be certain the economy has enough momentum behind it. Folks in this camp seem to favor keeping rates low for much longer, possibly until 2016.[3]

Keep in mind that such disagreements are healthy, because there is a lot of room for interpretation of economic data and debate about the effects of economic policy. However, these splits mean that Fed chairwoman Janet Yellen must craft a careful compromise at the October FOMC meeting or risk making financial markets nervous.

Why do these Fed decisions matter? The Fed has held interest rates at rock bottom levels in order to encourage lending and stoke economic activity. Now that the economy is improving, the Fed is starting to think about inflation - which they like to keep below 2% (headline inflation). By slowly raising rates, the Fed plans to avoid the specter of high or unexpected inflation, which can negatively affect the economy by chipping away at buying power. If the Fed raises rates too soon, the economic recovery could falter. If rates are left low too long, inflation could spike.

For bond investors, rising interest rates will affect the market prices of the bonds in their portfolios. As interest rates rise, bond prices fall as new bonds paying higher rates come on to the market. As financial professionals, we spend a lot of time managing these issues for our clients so that they are prepared for rising rates. Bottom line: We know higher interest rates are coming, we just don't know when. The good news is that the economy is doing reasonably well and the signs point to continued growth this year.

The minor decline last week wasn't unexpected. Markets have been trading at record highs and concerns about slowing growth in China and other threats to the global economy caused investors to hit pause ahead of the end of the quarter. Will the decline continue or will investors buy the dip? Hard to say. Looking ahead at the last week of the quarter, a lot of attention will be on the release of the September jobs report, which will hopefully underscore the labor markets improvements. However, a positive jobs report could be the evidence the Fed needs to move away from monetary stimulus, which could cause some market volatility. We'll know more once we start to see a trickle of Q3 earnings reports and quarterly economic data.

ECONOMIC CALENDAR:

Monday: Personal Income and Outlays, Pending Home Sales Index, Dallas Fed Mfg. Survey
Tuesday: S&P Case-Shiller HPI, Chicago PMI, Consumer Confidence
Wednesday: Motor Vehicle Sales, ADP Employment Report, PMI Manufacturing Index, ISM Mfg. Index, Construction Spending, EIA Petroleum Status Report
Thursday: Jobless Claims, Factory Orders
Friday: Employment Situation, International Trade, PMI Services Index, ISM Non-Mfg. Index

_{Notes: All index returns exclude reinvested dividends, and the 5-year and 10-year returns are annualized. Sources: Yahoo! Finance and Treasury.gov. International performance is represented by the MSCI EAFE Index. Corporate bond performance is represented by the DJCBP. Past performance is no guarantee of future results. Indices are unmanaged and cannot be invested into directly.}

HEADLINES:

Q2 GDP estimate rises to 4.6%. The third estimate of second quarter economic growth was revised upward again, largely driven by greater business and personal consumption. These are excellent indicators for greater growth this year.[4]

Durable goods orders fall. After July's surprise surge in aircraft orders, August orders for long-lasting manufactured goods fell. However, excluding the volatile transportation category, so-called core orders rebounded 0.7%, which is a healthy amount.[5]

Consumer sentiment measure reaches 14-month high. An index of consumer confidence reached the highest level seen since July 2013, also the second highest level in seven years. Americans feel more upbeat about economic growth and rising incomes, which could give consumer spending a needed boost.[6]

August new home sales swell. August sales of new single-family homes surged to their highest level in six years, supporting hopes that the housing market isn't done growing yet. However, low supply levels will likely continue to stunt sales activity.[7]