What Dec Rate Hike Means For ETFs

The Federal Reserve will hike rates in December. That's according to futures markets, which are currently predicting an 80% probability of a rate hike during the final Fed meeting of the year, a sharp increase from only a month ago, when the chance of an increase was closer to 20%.

If it occurs, a rate hike in December would mark the third time the Fed raised its benchmark overnight Federal Funds rate in 2017, and the fourth time it did so since December of last year.

What's caused the big uptick in interest rate expectations, and what does it mean for investors?

Traders Are Fickle

According to Brian Jacobsen, chief portfolio strategist at Wells Fargo Assets Management, it comes down to this: "Traders are fickle."

As large as the recent upswing in Fed rate hike expectations have been, it's not necessarily something investors should be paying too much attention to, he says.

Futures market probabilities "are probably a poor guide to what investors are really thinking and more reflective of how traders are feeling," he explained. "Objectively, the probabilities should be close to 80%. Subjectively, based on the whims of risk aversion, you can see these probabilities move all over the place."

"The fact is that the data support the notion that inflation is slowly moving toward the Fed’s target" and "the economic data has been pretty resilient, if not robust," Jacobsen noted.

Robust Economic Growth

Indeed, as Jacobsen points out, recent economic data releases have been strong, and that may be an understatement.

Earlier this month, the Institute for Supply Management (ISM) reported that its manufacturing PMI jumped to 60.8 in September, the loftiest level since 2004.

At the same time, the ISM nonmanufacturing index climbed to 59.8 during the month, the best reading since 2005.

Even September's nonfarm payrolls report, which was considered a downer by some because it showed the first contraction in jobs since 2010, also contained great news on the economy.

The unemployment rate fell to the lowest point since 2001, and average hourly earnings grew by 2.9% year-over-year, the fastest pace in eight years―both signs of a robust economy that may be accelerating.

Hawkish Fed

Along with strengthening economic data, some hawkish comments from key Fed officials may also be supporting the case for a December rate hike.

In a speech from late last month, Fed Chair Janet Yellen said a gradual tightening of monetary policy was required to prevent the economy from becoming overheated, "potentially creating an inflationary problem down the road."

We should be wary of moving "too gradually" when it comes to interest rate hikes, she warns―which some market observers interpreted as a signal for a December rate hike.

Bonds Hit Road Bump

With all the evidence pointing toward another interest rate increase this year, investors may be wondering what to do.

The stock market doesn't seem to mind the likely rate hike, as evidenced by the near-daily record highs in the S&P 500. On the other hand, the bond market is taking note.

Since the start of September, the 10-year Treasury yield shot up from around 2% to nearly 2.4%. Meanwhile, the yield on the two-year note topped 1.5% for the first time since 2008.

The iShares 20+ Year Treasury Bond ETF (TLT) sold off 3.8% since the rate reversal began last month (bond prices and yields move inversely), while the iShares Core U.S. Aggregate Bond ETF (AGG) lost about 0.8% in the same period.

To be sure, most bond ETFs are still up solidly for 2017 as a whole, but the latest move higher in rates has investors once again questioning whether this is the start of something more ominous for bonds― and by extension―stocks.

YTD Returns For TLT, AGG

Not Overdoing It With Hikes

Wells Fargo's Jacobsen doesn't think so. In his view, the Fed's move isn't going to derail the economy.

"It’s not the first hike that hurts, but the last one. The Fed isn’t close to being done hiking, and it’s also not close to overdoing it with hikes," he said.

"We can probably see the short end of the curve continue to move up, corporate spreads stay tight and stocks move higher," Jacobsen added.

He believes stocks are fairly valued, but that any upside surprises to economic growth and earnings growth could push shares to new records.

If we see upside surprises to growth, "that's good for equities," he said. "If we see upside surprises to inflation, that’s bad for the long end of the yield curve, but it’s benign for equities."

Lower Earnings Expectations

"As we enter earnings season, analysts have already lowered their expectations for earnings growth. All it takes is mediocre growth in earnings to get us through the end of the year,” Jacobsen remarked. “Congress wants to check out before Thanksgiving, so if Congress and the president come to terms on taxes, then maybe Santa will come early for investors.”

His one caveat is that if the economic data deteriorate before the December meeting but the Fed decides to hike, there could be an adverse market move.

"The Fed is intent on hiking, so track the data to see if it’s going to turn, as the Fed isn’t likely going to turn from its current course," Jacobsen advised.

Contact Sumit Roy at [email protected]