Fed policymakers no longer seem inclined to hike interest rates to get to neutral. Instead, they are more open to accepting some risk that inflation may increase and some would welcome inflation exceeding the Fed’s 2% target as an offset to inflation remaining below 2% for several years. The most important two consequences of such a policy approach are that it will likely extend the life of the expansion and increase the likelihood that inflation does exceed the 2% target for some period of time. Such an outcome would be positive for stocks and negative for bonds.
The tumultuous fourth quarter seems to have instigated a serious reevaluation of the path for monetary policy. Uncharitably, critics say the Fed buckled in response to stock price declines and criticism from the President. Magnanimously, one could say the Fed recognized that inflation failed to rise sharply as the labor market tightened, contrary to its fears, so it sees no need to raise rates prematurely until inflation becomes a more visible problem. And recall that the 2% inflation target has always been a target, not a ceiling, so we should really not be surprised that the Fed will allow inflation above 2%. The length of this hiatus from rate hikes will depend on the extent of wage and price pressures as 2019 progresses. We’d expect the Fed to move quickly if inflation looked like it was going to surge well above that target.
Regardless of whether you approve or disapprove of the Fed allowing inflation to run above its target, which is a wholly different issue I will not tackle here, as investors we must understand its implications to be able to make the appropriate investment decisions. The Fed will not be hiking interest rates in the near term and it is likely to announce within a few months that it will stop running down its investment portfolio. (The decline in mortgage holdings is likely to continue, but offset by an increase in Treasury holdings.)
The above described approach to policy implies highly favorable conditions for stocks to continue to rally. There is absolutely no better environment for stocks than 1) low inflation, 2) low interest rates, 3) stable monetary policy, 4) moderate economic growth, and 5) ongoing moderate earnings growth. It seems as if every single one of these optimal conditions for equities to rally will be in place through much of 2019. If the Fed chooses to keep rates unchanged, economic growth is most likely to continue along at a moderate pace. It may (and should) moderate somewhat from the fiscally stimulated pace of 2018, but an impending recession is unlikely. Even so, the global economy has weakened, and trade policy, while moving in the right direction, remains in flux. For now, market conditions remain favorable for equity investors in 2019, but tight labor markets, trade policy, and an upcoming election all have disruptive potential and bare watching.
The outlook for the bond market is less sanguine. While fewer rate hikes should relieve pressure on bond prices, higher inflation ultimately undermines real returns for bond holders. An unchanged monetary policy that is intended to test and permit some increase in inflation, even modestly above 2%, will hurt bond investors who own 10-year Treasuries now yielding 2.65%. Investors in the 37% tax bracket will net only 1.67% after taxes. At 2% inflation, they are earning a negative return on their investment of -0.33% annually for 10 years that will fall deeper into negative territory if inflation exceeds 2%. Investors need a pre-tax yield of 3.17% on Treasuries to break even at 2% inflation. So even if their bond prices do not decline in a slightly higher inflation environment, bond investments are actually rather unattractive.
Investors who want to hold bonds are NOT being irrational. Bond investments are hedges against highly unfavorable developments and the losses on these holdings are akin to premiums paid to insure against market shocks. So this loss in buying power is the effective price investors are willing to pay to know that some fraction of their portfolios will be immune to many forms of shocks. The full cost of this insurance premium is this loss of buying power plus the opportunity cost of not having had the capital deployed into an asset providing a higher return.
But just as a homeowner’s policy protects against some risks, such as fire, it does not protect against all risks, such as floods. A separate policy must be purchased for that protection. With bonds, investors remain highly vulnerable to higher inflation. So the “premium” paid to protect against shocks is itself subject to change and directly sensitive to inflation. And given the change in the Fed’s policy direction, bond investors are likely to pay a higher cost over time.