Yesterday’s Fed Hike Could Trigger The Next Recession

When you think of all the major risks investors face, “the Federal Reserve” probably isn’t on the top of your list.

But the Fed members hold a lot of power in their hands: For example, when the FOMC — the policy-making arm of the Federal Reserve — announces a policy decision, the market typically reacts with large price moves.

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This has been true since the Fed was created more than 100 years ago, and the committee recognizes this problem. Over the past 10 years, they have been trying to keep the market informed about policy changes with better communications and quarterly press conferences. 

That’s why seemingly everyone — economists, analysts and investors alike — were watching closely when the Fed announced an interest rate hike to 1.25% to 1.5% at the end of yesterday’s policy meeting. 

#-ad_banner-#Before the announcement, futures traders were telling us a rate hike is basically guaranteed, although they were split on how large it would be. The overwhelming majority (85%) were correct in expecting the Fed to raise rates to a range of 1.25% to 1.5%, while the other 15% thought the Fed would target a range of 1.5% to 1.75%.

No one was expecting the fed to keep rates the same.

And that makes sense: The Fed generally only keeps rates at low levels to encourage economic growth. When interest rates are low, it’s cheaper to borrow money, which means consumers spend more (buying homes, cars, etc.) and businesses grow and expand.

But all the current data point to an economy firing on all cylinders. The workforce has been near full employment (unemployment rate below 5%) for more than a year. People are making (and spending) more money. The stock market is at record highs. On top of everything else, Congress is poised to pass major tax legislation, which many economists believe will further increase economic growth — at least for the short term. 

This rate increase is simply the next step in weaning the U.S. economy off the stimulus it needed to overcome the Great Recession.

It could also be the nudge that accidentally sends the economy off the edge of a cliff.

You see, according to research from Wells Fargo economists, the Fed’s current policy path puts us on track for another recession.

In mid-September, this group of economists released a special report detailing their research on a simple recession indicator: In a rising rate environment, when the fed funds rate touches or crosses the lowest level of the 10-year Treasury yield in that cycle, we should expect a recession.

When tested, their framework successfully gave signals for all nine recessions that have occurred since 1955… but gave a total of 13 signals. (And of those four false positive signals, three came right before market selloffs. On average, the S&P 500 fell 11% within a year of those signals.)

Currently, the lowest 10-year Treasury yield from this monetary cycle is 1.36%, which was hit in July 2016. When the Fed announced a 0.25% rate hike yesterday, it pushed the fed funds rate to 1.5% — above the 1.36% low for the 10-year Treasury yield.

That means that the Fed could have triggered a recession with yesterday’s announcement.

Of course, this isn’t a precise market timing tool. Recessions followed signals by six to 34 months in the past, with an average lead time of 17 months. That framework puts us on track for a recession starting in the last months of 2018 or sometime in 2019.

Typically, stock prices fall before the recession begins. That means the current bull market could be nearing its end. Analysts have been saying that for years, and it is absolutely true that the bull market will certainly end one day.

But that’s not necessarily the most important conclusion income investors need to take from this analysis…

This is: Based on Wells Fargo’s recession indicator, interest rates are now likely to remain near historic lows for the next few years.

As I mentioned earlier, in a recession, the Federal Reserve cuts interest rates in order to stimulate borrowing and economic growth. Traders expect the fed funds rate to be less than 2% a year from now, so if a recession occurs in 2019, the Fed would be cutting rates from that level.

This means traditional fixed-income investments will continue to provide paltry levels of income.

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