Action and Reaction

Last month we talked about actions speaking louder than words.  Well, this month we are beginning to see an outline of what healthcare reform might look like: a replacement plan for the Affordable Care Act has made its way through the House Ways and Means committee.  Next stop: Congress.  Another “action” is coming from the Federal Reserve.  In a very orchestrated effort the Fed Governors en masse got out the “word” that the US economy is healthy enough for a rate hike.  And by all measures, it appears that the Federal Reserve is set to increase rates during its upcoming March meeting.  The equity markets have taken this in stride, with major US equity indices keeping near their recent historic highs.  As markets were making new highs towards the end of February, we saw volatility start to increase as well.  Let’s focus on a few things that we believe might contribute to future volatility.

As we mentioned previously, Federal Reserve officials are out talking about rate hikes, and this time they apparently mean it.  We realize this sounds like a tagline to a bad movie sequel, but this is the same Fed that promised four rate hikes last year, and delivered only one.  So what is different about the message this time?  To our recollection, this is the first time in a long while we have seen all the Fed officials speaking with such solidarity.  And the message is rate hike.  Futures markets are pricing in a greater-than-95% chance that the Fed will raise rates during their March 14th and 15th meeting (which may have already happened by the time you read this). 

If we can take the Fed at their “word”, this would be the first of three planned rate increases for this year, according to previous Fed comments.  This is coming at a time when Japan and Europe continue to appear committed to keeping their rates low.  This is noteworthy for two reasons.  First, it is a signal from the Fed that the US economy is healthy enough to withstand the ramifications of modest rate increases.  Second, it also creates a scenario for dollar strength.  As rates on US Treasury bonds increase, foreign buyers will find US bonds more attractive than their home-country bonds and will want to buy them.  Their need to sell their own currency and buy dollars in order to purchase our bonds would contribute to dollar strength, provided they don’t hedge currency movements.  A strong dollar potentially hurts US exporters, as well as emerging market entities that have issued debt in US dollars.  If this scenario plays out, we will likely see more volatility.

There is also the GOP’s desire to repeal the Affordable Care Act, cut regulation, and reform taxes…something the equity markets have liked.  We believe that the equity market’s current pause is in part due to investors’ desire to see more than just talk...to see policy catch up with equity markets.  As we write, House Speaker Paul Ryan is out promoting the President’s “A Better Way” healthcare plan as part of the initiative to “repeal and replace” the ACA.  While the proposal is out of committee, there seems to be some dissention in the GOP ranks as to what the best health care plan is for America.  We believe equity markets see this more simply.  They want to see plans that promote sustainable improvements in economic growth.  Without such plans, we will likely see more volatility.

And Finally, we are keeping an eye on Britain.  Let’s not forget our European friends who unexpectedly voted to leave the European Union last June.  As you remember, the vote was just the first step in the process for the British exit, or “Brexit”.  Now it’s up to Parliament.  The English Parliament is widely expected to enact article 50 later in March.  At that point, Brexit will be official. Great Britain will begin the two-year process of negotiating its departure from the European Union, which involves negotiating new trade agreements. If this is in any way seen as disruptive to global markets, we will see volatility increase as a result.

It appears that the Fed, US policy makers, and our friends across the pond are all ready to act.  The goal is to act in ways that are productive and in some cases already predicted.  The current outlines for action certainly bring with them the possibility for market volatility.  And we will continue to pay attention to the words being said and, more importantly, look for and evaluate the actions taken.