Take Five with U.S. Bank: Signs point to interest rate hike from Fed

Federal Reserve Board Chairman Janet Yellen raised a few eyebrows recently when she opined that market valuation (i.e., stock prices) are generally “quite high.” Some took that as an admission that the Fed’s own quantitative easing policy has created another bubble that eventually will burst. Others compared it to Alan Greenspan’s warning about “irrational exuberance” in late 1996. Dave Heidel, regional investment director, The Private Client Reserve of U.S. Bank, and Mark Consigny, vice president and senior investment portfolio manager for U.S. Bank, recently took time to put her comments into perspective.

IB: What do the two of you make of Chairman Yellen’s comments? Was she laying the groundwork for an interest rate hike later this year?

Consigny: That isn’t inconsistent, her statement. It could be argued whether she should be involved in calling the valuation of the stock market in her role, but with regard to interest rates and the positioning of interest rates later in the year, it’s not a matter of if they are going to raise, it’s a matter of when. The Federal Reserve has done a masterful job as far as transmitting to the general market that they are ready to begin the period of rising interest rates. They can only do it during periods when they meet. With that, even though we expect the Fed to start raising interest rates later this year, it doesn’t necessarily mean it will have a dramatically negative impact on stocks themselves. In fact, right now, in our position from an asset allocation standpoint, we are still comfortable being overweight in equities relative to fixed-income in our client portfolios.

Heidel: First of all, I’m not real thrilled when Fed officials talk about the stock market. It bugs me a little bit because I worry about the message she’s trying to send, and especially because so many of the policies of the Federal Reserve show up in the stock market. That said, I’m not sure why she made the comments, but I do believe strongly that Chairman Yellen and the rest of the Federal Reserve would very much like to see interest rates go up, the discount rate go up. The reason is that right now the Fed has its back against the wall.

If we have a cyclical downturn with the economy, which can happen for various reasons, they have no latitude to be able to exert a stimulative affect through monetary policy with their back against the wall at a 0–2.5% rate. They would very much like to take a step or two away from the wall and bring rates up to a more normal level, which, by the way would send a signal to global capital markets that they had some confidence in U.S. growth and recovery continuing.

They can only do it gradually, and quite frankly with the data that’s come out over the past few months, they have a real problem. They revised their forecasts, and based on the data that’s come out I would be shocked if they didn’t revise their growth rates lower. Think about the odd juxtaposition of them lowering their inflation and growth rate targets, and then also simultaneously raising rates in June. I think they have a real problem. Right now, the data is not supporting a rate increase. The thing that’s a little bit disconcerting is that may not stop them from raising rates just because they want to get out of the corner that they are in. Unless things change dramatically over the summer and into fall, they are going to be raising rates in the face of economic data that shows tepid growth and very little inflation pressure.



IB: The U.S. economy went into reverse in the first three months of this year as a severe winter and a widening trade deficit took a harsher toll than initially estimated. The overall economy as measured by the gross domestic product contracted at an annual rate of 0.7% in the January–March period, the Commerce Department reported May 29.

The revised figure, even weaker than the government’s initial estimate of a 0.2% growth rate, reflects a bigger trade gap and slower consumer spending. It also marked the first decline since a 2.1% contraction in the first three months of 2014. In the rest of 2014 the economy grew, but some believe it still grew too modestly. Do you expect the same scenario to unfold in the remainder of 2015?

Heidel: It’s interesting. In 2014, we had a very disappointing first quarter, and it was blamed on bad weather. And then we had an extremely strong rebound in the second quarter, and pretty good growth the rest of the year. So what’s interesting is that if you look from year to year, from the end of the first quarter of 2014 to the end of the first quarter of 2015, the U.S. economy actually grew at 3%, so not bad. I think that’s a growth rate that people would be somewhat happy with.

However, if you look at the growth rate in the first quarter, it was barely positive. Call it flat, and revisions might even turn that into a negative number. Now the sluggishness in the first quarter is blamed on a number of things: the weather, which wasn’t great in the Northeast; the port strike out on the West Coast, which did cause some supply chain disruptions; and it was partly blamed on the fact that gas prices actually bounced back a little bit in the first quarter, which is interesting because before that everybody had been counting on stimulus from cheaper gas prices.

Net–net, that still was stimulative, but here’s what’s interesting: Instantly the expectations were, ‘Well, we’ll have a similar, significant bounce back like we had in 2014.’ From all indications that we’re seeing, it doesn’t look like we’re going to get nearly as strong a bounce back as we did in 2014 and subsequent quarters. I would argue there are various different reasons for that, and in fact there may be some underlying structural ones. There also may be some shorter-term reasons. Although we’ve had very strong jobs numbers, there is actually less confidence among those who have jobs and those seeking jobs. Also, consumer confidence has dipped a little bit. We’re not going to see no growth like we saw in the first quarter, but I think we’re going to be challenged for strong growth. We’re going to see growth that maybe disappoints, that’s closer to the low 2%, as opposed to over 3% that many people, including the Fed, are counting on.

Consigny: I totally agree with that, but I think that isn’t necessarily a bad case. As we overlay our outlook on equity and fixed income, many would say that almost represents a Goldilocks scenario, where our economic growth is enough to provide a support level for stocks and yet it is not so robust to the point where the Federal Reserve has to come in and rapidly raise interest rates. So you could have reasonable returns in both stocks and bonds in that low-growth scenario.

IB: When the Fed does begin to raise interest rates, will it still be somewhat tempered in terms of how fast or how steeply it raises rates by the fact that a steep increase could really jack up the cost of the federal government’s borrowing, and therefore the size of the federal deficit? Or are there a host of constraining factors, starting with modest economic growth?

Heidel: Well, one of the things they are concerned about is if they raise rates rapidly, what is the effect on the dollar? When there was a significant amount of concern that they were going to launch into a program earlier in 2015, you saw a pretty strong rally on the dollar. So the dollar has already strenghtened, and I don’t think they want to see it strenthen significantly because of the effect it would have on the American economy and on global trade. The also don’t want to crush the modest but substantive job growth that we’ve had. They don’t want to see that crushed by companies having to re-evaluate their borrowing costs and maybe see their stocks come down in price.

IB: Is there anything out there that worries you, whether it be an economic fundamental that’s keeping you up at night, or perhaps something else that’s been unfolding, an example being the so-called toxic debt that was accumulating in the banks before the financial crisis of 2008?

Consigny: From my standpoint, not really. As we look at the outlook for stocks and bonds, we have to put our blinders on to alleviate a lot of the aberration that could always be out there. When we really put our blinders on and focus on the fundamentals, either the stocks or the bonds, again I come back to the fact that we may be — and it’s counterintuitive — we may be in this Goldilocks scenario where our economy is growing just enough to continue supporting stock prices and not so fast as to compel the Fed to rapidly raise rates.

Heidel: I would agree. What’s ironic is I don’t see things that trouble me in the short to intermediate term. I have a lot of questions in the longer term, but in the short to intermediate term, things look relatively favorable for capital markets.

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