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Interest Rates

Forget the Fed’s First Rate Hike and Look at the Bigger Picture

By Elliott H. Gue, on Nov. 3, 2015

As expected, the Federal Reserve left interest rates unchanged last Wednesday; however, the market reacted to some key changes in the Federal Open Market Committee’s (FOMC) Oct. 28 statement relative to the Sept. 17 press release:

  • Household spending and fixed investments by businesses have increased at “solid” rates in recent months, as opposed “increasing moderately.”
  • The most recent FOMC statement omitted this controversial phrase: “Recent global economic and financial developments may restrain economic activity somewhat and are likely to put further downward pressure on inflation in the near term.”
  • The Oct. 28 statement added the following language: “In determining whether it will be appropriate to raise the target rate at its next meeting, the Committee will assess progress….”

The first emendation suggests that the FOMC’s outlook for the US economy has improved slightly, while omitting its previous commentary on global economic activity and a lack of inflation–a big part of the rationale behind September’s decision not to hike interest rates. Meanwhile, the third change introduces the possibility of a December rate hike.

The market reacted to the FOMC statement by increasing the odds of a 25-basis point hike at the Fed’s Dec. 16 meeting to about 50 percent, compared with 35 percent on Oct. 27. Prior to the FOMC’s most recent meeting, the futures market attached a 58 percent probability to the Fed raising interest rates before March 16; this likelihood had surged to 71.6 percent at the end of Friday’s trading session.

Utility stocks and other dividend-paying equities tend to suffer a knee-jerk selloff when the odds of a Fed rate hike increase. However, despite the conventional wisdom often spouted in the financial infotainment industry, utility stocks historically have performed well when interest rates rise–probably because their returns hew more closely to the S&P 500 than the yield on 10-year Treasury notes.

Weak US economic data suggest that the Fed won’t hike rates at its Dec. 16 meeting; we view the changes to the October FOMC statement as an attempt to manage the market’s expectations.

The US central bank already failed to deliver expected rate increases in June and September 2015, while dovish comments after the September meeting shifted the market’s expectations for the impending tightening cycle to start in March 2016 or later.

The Federal Reserve doesn’t want the market to be surprised when the tightening cycle starts; the FOMC’s most recent comments keep the option of a December rate hike on the table, underscoring the imminence of this decision and adjusting the market’s consensus expectations accordingly.

Although a rate hike would represent a shift in policy, economic weakness in China, Europe and the US suggests that this tightening cycle likely will occur at the most gradual pace in history.

The futures market has priced in the Federal Reserve keeping the benchmark interest rate at less than 1 percent through December 2017. In contrast, the Fed hiked interest rates by 425 basis points during the 2004-06 tightening cycle.

Expect the Fed to remain cautious after implementing its first rate hike; the central bank will monitor the economy closely before proceeding with another increase. Caution and transparency are critical at this juncture–nobody at the Fed wants a policy accident.

If this scenario plays out, dividend-paying equities will continue to entice investors seeking an alternative to government bonds.

Taking Advantage

 

Conrad’s Utility Investor readers recently booked an 81 percent gain on Piedmont Natural Gas (NYSE: PNY) and a 66 percent gain on WGL Holdings (NYSE: WGL), locking in profits equivalent to many years’ worth of dividends and raising dry powder for future buying opportunities.

With technical indicators suggesting US equities could be entering bear-market territory next year, savvy investors could have an excellent opportunity to purchase high-quality utility stocks

Next week, my colleague Roger Conrad will attend the Edison Electric Institute’s 50th annual financial conference–the premier event for utility analysts and industry insiders. Roger expects his conversations and takeaways from this conference to help him finalize his top utility stocks for 2016.

If you haven’t joined Conrad’s Utility Investor yet, sign up for a risk-free trial today to ensure your access to Roger’s exclusive report on his takeaways and top picks from the Edison Electric Institute’s upcoming conference and his next Live Chat with subscribers in early December.

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