US stocks fall sharply on Fed rate rise

US equity investors delivered their sharpest response to an interest rate rise since 1994, after Federal Reserve chairman Jay Powell set out the reasoning behind the central bank's decision to lower its forecasts for next year.

The Federal Reserve defied pressure from Donald Trump and equity investors by boosting rates for the fourth time this year even as it flagged up risks from stormy markets and slower overseas growth.

Mr Powell, who was addressing reporters at the central bank’s post-meeting press conference, also unnerved investors further in saying that he did not see the central bank changing its “autopilot” policy of reducing the Fed’s balance sheet.

Negative

The S&P 500 dropped as much as 2.3 per cent, having been up 1.5 per cent before the Fed decision. At the closing bell, it was down 1.5 per cent, marking the most negative stock market reaction to a Fed rate rise since February 1994 – a year in which it boosted rates by a cumulative 2.5 percentage points.

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Treasuries rallied as yields turned sharply lower, with the yield on the 30-year US Treasury sinking below 3 per cent for the first time in almost three months as the Fed’s forecasts showed a lower “neutral” rate in the longer-term.

The US central bank lifted the target range for the federal funds rate by another quarter point to 2.25-2.5 per cent, in a unanimous decision. But in paring back its forecasts for further increases it indicated that it was less certain about future moves.

Despite signalling that it would raise rates more slowly next year, US stocks turned down sharply in the immediate aftermath of the decision as investors had priced in an even more dovish stance.

“The market was looking for a little more than what they got,” said Ian Lyngen, head of US rates strategy at BMO Capital Markets. “It was a nod to a fact that risk assets are underperforming and what is going on overseas is concerning but as we learned today it’s not concerning enough to stop the Fed.”

“They don’t recognise how bad the markets are and that is what you are seeing,” said Andrew Brenner, head of international fixed income at National Alliance Securities. “I am very concerned.”

Fed chairman Jay Powell is navigating a delicate path as he weighs a strong domestic economy against signs of slowing growth overseas and punishing losses on equity markets. The president has added to the turbulence by publicly lobbying the Fed to keep rates unchanged and expressing personal dissatisfaction in Mr Powell, whom he placed in the central bank’s chair.

Considerations

Speaking at a press conference, Mr Powell insisted that political considerations were playing “no role whatsoever” in the Fed’s discussions and decisions on monetary policy. He said that policy no longer needed to be accommodative - or supportive of the economy - and that there was now considerable uncertainty about the pace and destination of rate moves.

In its statement on Wednesday, the Fed highlighted market turbulence, saying it will “continue to monitor global economic and financial developments and assess their implications for the economic outlook.”

It also tweaked the wording in its statement to show less conviction about the rates outlook. The Fed has recently been saying it “expects that further gradual increases” in rates will be needed. Now the central bank “judges that some further gradual increases” are on the cards.

The new wording reflected a more cautious Fed that is shifting into a data-dependent phase where it is less sure where rates will go next. This is in part because rates are getting closer to “neutral” settings that neither stimulate the economy nor hold it back. Core inflation has also remained tepid, at 1.8 per cent, lessening the pressure for more rate increases.

In its statement, the Fed stuck with its bullish assessment of the economy’s performance, saying that jobs, household spending and economic activity had been growing strongly.

The so-called dot plot of rates forecasts by Fed officials now shows two quarter-point increases in short-term rates in 2019, down from three in the prior forecast. Another single rate rise may follow in 2020, according to the median forecast, leaving the midpoint of the target range at 3.1 per cent - the apparent peak of the rate-rising programme.

Forecasts

The central bank trimmed its forecasts for growth next year to 2.3 per cent from 2.5 per cent, while leaving its unemployment prediction for 2019 unchanged at 3.5 per cent. Core inflation forecasts were pared back to 2 per cent in 2019, 2020 and 2021 from 2.1 per cent previously.

Mr Powell has been through a choppy period in which his signalling has stoked some confusion in markets. In October the chairman gave a highly upbeat assessment of the US economy that prompted stock market turbulence as investors banked on a succession of further rate rises.

He altered his message in a November speech that sent markets surging as he indicated the central bank may not need to lift rates far to get them into the “neutral” range of estimates.

The Fed’s new forecasts show a lower projection for the neutral rate than previously: the midpoint of its estimates now stands at 2.8 per cent compared with 3 per cent earlier.

The key question in investors’ minds ahead of the latest policymaker meeting has been how close the Fed is to a peak in its rate-rising cycle and whether it is teeing up a “pause” in tightening in March. Complicating the outlook is a broadening range of so-called downside risks confronting the US economy.

These include the churning financial markets, slowing growth in Asia and Europe, trade tensions, the possible fading of the fiscal stimulus implemented at the start of the year, and the drag on the economy from past rate rises that started in December 2015. – Copyright The Financial Times Limited 2018