As we all know, raising interest rates is not going to be easy.
On the one hand, higher interest rates could strengthen the dollar, which hurts profits. It could also affect consumer behavior and risk popping the bubble in auto and student loans.
On the other hand, leaving rates as low as they are risks inflation and hurts the financial sector.
The Federal Open Market Committee (FOMC) doesn’t have a clear way out of this dilemma. Raising or lowering rates have unpredictable consequences in a market that is already jittery. This is an important topic because of the position the Fed took in yesterday’s statement.
The Fed acknowledged that risks have “diminished” and pointed to strength in employment and household spending, but it did not provide very strong hints about a rate hike in September. Despite the wishy-washy statement, the early reaction in the market seemed to be an increase in expectations that the overnight rate will be raised in September because the dollar is rising.
But Will the FOMC?
However, expectations for growth could be a very different issue.
Bonds rose early after the Fed’s announcement, which means investors are expecting longer-term interest rates to fall. Longer-term rates can be viewed as an index of future growth estimates. If investors think the real economy will grow, then longer-term interest rates tend to be pushed up by inflation. Yesterday’s reaction seems to indicate that traders just aren’t expecting a big shift in the underlying fundamentals.
If expectations for short-term interest rates have risen while longer-term rates are anticipated to be flat or to fall, that puts pressure on the yield curve. This matters because profitability in the financial sector is largely a function of the yield curve. The flatter the yield curve gets, the lower profitability is in the financial sector, and that is usually a bad thing for stocks in general.
As you can see in the chart below, financial stocks have been stuck at resistance since July 14, with very little range over the last two weeks. That consolidation zone happens to be at a very firm level of resistance, which also aligns with the top of the market before the 2014 correction.
SPDR Financial ETF (XLF): Chart source – TradingView
The statement yesterday was probably written in a way to increase confidence in the economy without making investors too worried about rising interest rates. In that respect, I think the Fed was probably successful. However, we know that the reaction in the market on FOMC days is not a very good predictor for where prices will be in the next 30 to 60 days.
Although earnings have been slightly better than expected, the net result so far is still a contraction in bottom-line growth. This fundamental issue will likely still keep the rally under a short-term cap. As a result, we will continue to be flexible with the trades we are taking.
Short time-horizons and a balance between bullish and bearish trades should work well in a market like this.
InvestorPlace advisors John Jagerson and S. Wade Hansen, both Chartered Market Technician (CMT) designees, are co-founders of LearningMarkets.com, as well as the co-editors of SlingShot Trader, a trading service designed to help you make options profits by trading the news. Get in on the next trade and get 1 free month today by clicking here.
