Wall Street's Trumphoria is giving way to Fedphobia

The Dow Jones industrials index rose again on Monday, continuing the post-election Trumphoria rally. Investor sentiment was bolstered by the weekend agreement between OPEC and non-OPEC oil producers (mainly Russia and Mexico) to limit output in an effort to bolster prices. This lifted crude oil and energy stocks.

And it helped the Dow inch ever closer to the 20,000 benchmark.  

But some apprehension is perhaps creeping in, with the S&P 500, Nasdaq and Russell 2000 indexes moving lower on Monday ahead of an expected interest rate hike from the Federal Reserve later this week.

Central bank policymakers will kick off their two-day meeting on Tuesday with the rate announcement coming on Wednesday afternoon. In addition to the Fed’s policy decision, investors will get updates to its economic forecasts including the latest “dot plot” forecast of the interest rate path into 2017 and beyond.

According to the futures market, traders are currently giving more than 95 percent odds of another quarter-point rate hike (following the quarter-point hike in December 2015, which was the first increase since 2006).

Why? Because much is going right in the U.S. economy.

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The stock market has pushed powerfully to new highs. Economic growth has rebounded, with the Atlanta Fed’s GDPNow estimate of fourth-quarter growth now coming in at 2.6 percent. The two-year corporate earnings recession is over as S&P 500 companies returned to year-over-year profits growth in the third quarter, thanks in part to the rebound in energy prices. The labor market is strong, with the unemployment rate fell to 4.6 percent in November.

And most important, inflationary pressures are building (chart above) because of the rise in energy prices and evidence of nascent wage pressure amid a stalling in labor productivity.

Deutsche Bank economists also noted that the gap between the Fed’s forecasts of the long-run federal funds rate and market expectations has closed. The market has now come up to where the Fed was. This was a big deal because the gap was 0.9 percent in March 2014 but widened to 1.8 percent in September -- reflecting the broad uncertainty on Wall Street heading into the U.S. presidential election and fear that a rate hike before year-end would be a policy mistake.

Sentiment has shifted now, however, due to what Deutsche Bank identifies as “expectations of improved growth and inflation.” No doubt, much of this stems from anticipation of stimulative fiscal policy from President-elect Donald Trump.

With a hike this week essentially in the bag, what should investors expect heading into 2017? The Fed’s forecast from September has four quarter-point hikes penciled in. Oxford Economics is looking for only two, given uncertainty related to the recent surge in long-term interest rates (with possible negative impacts on housing and auto sales), the dollar’s rise and the uncertain legislative outcome of Mr. Trump’s initiatives.

Whether the stock market tolerates the rate hike well depends, in large part, on the flow of economic data in the weeks to come that reveal how well the economy is handling the increase in credit costs. 

  • Anthony Mirhaydari

    Anthony Mirhaydari is founder of the Edge , an investment advisory newsletter, and Edge Pro, options newsletter. Previously, he was a markets columnist for MSN Money; a senior research analyst with Markman Capital Insight, a money management firm; and an analyst with Moss Adams focusing on the financial services industry.