U.S. equities mostly finished lower on Wednesday after the latest Federal Reserve policy statement revealed a more optimistic outlook for the economy. The key phrase: near-term risks to the economic outlook had “diminished.”
As a result, Wall Street is increasingly worried that another interest rate hike could hit in as soon as two months, as officials acknowledged ongoing strength in the labor market, the Brexit non-event and ongoing evidence of firming inflation (especially in housing).
Yet, with uneven economic data and Asia and Europe still a mess, the financial market response to rising Fed hike expectations was clear: It’s a mistake.
In the end, the Dow Jones Industrial Average lost a fraction, the S&P 500 Index lost 0.1%, the Nasdaq Composite gained 0.6% and the Russell 2000 gained 0.2%. Treasury bonds were stronger (on safe haven inflows), the dollar was weaker, gold gained 0.5% and crude oil lost 2.3%.
Oil was hit once again on inventory concerns, resulting in its fifth consecutive decline. Department of Energy data showed a 1.7-million-barrel crude oil build vs. expectations for a draw of more than 2 million. Gasoline inventories also grew, fueling fears of an acute oversupply in refined products.
This all boosted the Exxon Mobil Corporation (NYSE:XOM) Aug $94 puts recommended to Edge Pro subscribers to a gain of near 60%.
Technology stocks led the way with a 0.8% gain thanks to a 6.6% rise in Apple Inc. (NASDAQ:AAPL), surging above its 200-day moving average for the first time since April after beating earnings Tuesday night. The result was driven by higher-than-expected shipments of iPhones and iPads.
Investors were encouraged despite the second consecutive quarter of falling profitability and sales. Apple also suggested that the weakness would continue into the third quarter, as iPhone demand wanes (down 15% year-over-year) ahead of an expected incremental update to the iPhone. Sales in China were also soft. And margins declined (38% vs. 39.7% last year) as the iPhone SE put a bit of a dent on Apple’s average selling price.
The negative market response wasn’t exactly surprising: Markets are still very dependent on the flow of cheap money stimulus and are simply not excited about the prospect of rate hikes in September and December if the Fed’s “dot-plot” interest rate forecast from June is to be believed. (The futures market doesn’t assign better-than-even odds of a rate hike until December.)
After the close, Facebook Inc (NASDAQ:FB) surged 6.4% on a top- and bottom-line beat driven by healthy user metrics and an expansion in profit margins as the company focuses on growing its video offering. Action camera maker GoPro Inc (NASDAQ:GPRO) gained 1.6% in extended trading on a smaller-than-expected loss and better revenues as investors look ahead to the launch of the HERO5 camera and the Karma video drone amid hopes of a return to profitability.
Turning back to the Fed.
The reason, as shown above, for all the weeping and gnashing of teeth over the threat of further rate hikes is that the economy is increasingly vulnerable and demonstrating late business cycle behavior. Higher short-term interest rates in this environment will invert the yield curve — the difference between long-term and short-term interest rates — which is the holy grail of economic recession indicators.
So why is the Fed turning hawkish? Well, stocks are just below record highs, the unemployment rate is below 5%, and inflation is becoming a problem.
Goldman Sachs believes while there is only a 30% chance of a September hike, there is a 70% chance the Fed will hike before the end of the year. It was also notable that the lone dissenter in the July policy decision, Kansas City Fed President Esther George, voted for an immediate rate hike. Internally, the dynamics around the table in the Marriner S. Eccles could very well be turning.
We’ll know more when Federal Reserve Board Chair Janet Yellen speaks at the central bank symposium in Jackson Hole, Wyoming in August. Also watch for the July jobs report in early August. If the market disruption continues, the Fed will surely backtrack, as it has so often during this bull market; whether it’s the 2013 “taper tantrum” or the September 2015 “no hike” decision.
With inflation rising, but still low, the Fed has the luxury of being able to err on the side of an easier policy stance justified by low “headline” inflation.
But with ongoing tightening in the labor market and whiffs of inflation coming from the housing market (where shelter and rent costs are rising fast), this luxury might not last much longer as “core” inflation — which was its preferred measure when oil surged in 2011 — pushes higher.
The outlook feels stagflationary, which would be the Fed’s nightmare scenario.
Anthony Mirhaydari is founder of the Edge and Edge Pro investment advisory newsletters. A two-week and four-week free trial offer has been extended to InvestorPlace readers.
