Morgan Stanley
  • Wealth Management
  • Nov 4, 2019

What If the Fed’s Next Move Is No Move?

The Fed lowered interest rates again recently, but signaled it may hold off on further rate cuts going forward. That could cause markets to stall.

Lisa Shalett Chief Investment Officer, Wealth Management

On October 30, the Federal Reserve’s Open Market Committee voted to cut short-term interest rates for the third time this year. At the same time, officials indicated they may not cut rates any further in 2019 as the economy seems to be stabilizing and the job market is healthy.

Markets took this news in stride, continuing to ignore the recession in manufacturing and flagging corporate earnings growth. The S&P 500 is up 24% this year and closed Nov. 1 at an all-time high as investors pin their hopes for more stock market gains on a strong U.S. consumer and easing trade tensions. 

I think the recent Fed decision matters. Below are three reasons investors should pay attention to the likely pause in rate cuts:

  • Treasury futures markets have priced in additional rate cuts, indicating that investors expect more than one additional cut through next year. If the Fed doesn’t reduce interest rates further, the yield curve, an important economic indicator based on government bond market prices, could flatten. That, in turn, could make some stock investors rethink positions they took based on expectations for more rate cuts and faster economic growth ahead.

  • Stock valuations could be too high. One reason stocks have risen this year is that equities are often valued based on their ability to earn more than the benchmark Treasury yield. If rates don’t fall as low as investors have anticipated, stocks may need to be repriced. Earnings growth is now slightly negative year over year and positive earnings gains rely on economic growth, which may not materialize. At the recent all-time high, S&P 500 stocks were priced at 18.5 times forward earnings, a historically high level. I expect markets to remain directionless for at least the next couple of months.

  • The dollar may be stuck in a range against a basket of foreign currencies. Prospects for additional rate cuts have contributed to a weaker dollar, a positive for U.S. exporters, commodity prices and the many emerging market nations that issue dollar-denominated debt. With the Fed pause, the dollar is likely to stay in the current range.

Range Bound Markets

It’s not just the dollar. I expect U.S. stock and bond markets to remain directionless for at least the next couple of months, now that the Fed monetary policy lever is apparently halted for now. Investors must rely on economic and earnings improvements to drive further gains. Until those improvements materialize, actively-managed funds, not index funds, are likely to be the stronger performers.

Risk Considerations

Yields are subject to change with economic conditions. Yield is only one factor that should be considered when making an investment decision.

Equity securities may fluctuate in response to news on companies, industries, market conditions and general economic environment.

Bonds are subject to interest rate risk. When interest rates rise, bond prices fall; generally the longer a bond's maturity, the more sensitive it is to this risk. Bonds may also be subject to call risk, which is the risk that the issuer will redeem the debt at its option, fully or partially, before the scheduled maturity date. The market value of debt instruments may fluctuate, and proceeds from sales prior to maturity may be more or less than the amount originally invested or the maturity value due to changes in market conditions or changes in the credit quality of the issuer. Bonds are subject to the credit risk of the issuer. This is the risk that the issuer might be unable to make interest and/or principal payments on a timely basis. Bonds are also subject to reinvestment risk, which is the risk that principal and/or interest payments from a given investment may be reinvested at a lower interest rate.

Asset allocation and diversification do not assure a profit or protect against loss in declining financial markets.

Rebalancing does not protect against a loss in declining financial markets.  There may be a potential tax implication with a rebalancing strategy.  Investors should consult with their tax advisor before implementing such a strategy.

Because of their narrow focus, sector investments tend to be more volatile than investments that diversify across many sectors and companies.  Technology stocks may be especially volatile.

International investing entails greater risk, as well as greater potential rewards compared to U.S. investing. These risks include political and economic uncertainties of foreign countries as well as the risk of currency fluctuations. These risks are magnified in countries with emerging markets, since these countries may have relatively unstable governments and less established markets and economies.

Investing in foreign emerging markets entails greater risks than those normally associated with domestic markets, such as political, currency, economic and market risks.

Investing in commodities entails significant risks. Commodity prices may be affected by a variety of factors at any time, including but not limited to, (i) changes in supply and demand relationships, (ii) governmental programs and policies, (iii) national and international political and economic events, war and terrorist events, (iv) changes in interest and exchange rates, (v) trading activities in commodities and related contracts, (vi) pestilence, technological change and weather, and (vii) the price volatility of a commodity. In addition, the commodities markets are subject to temporary distortions or other disruptions due to various factors, including lack of liquidity, participation of speculators and government intervention.

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