The U.S. Federal Reserve delivered what most economists had been expecting with its monetary policy decision on Wednesday: It hiked its key rate by a quarter of a percentage point and signalled a slower pace of rate hikes next year, reflecting confidence in the U.S. economy and an awareness of moderating economic growth ahead.
Yet U.S. and Canadian stocks fell sharply in afternoon trading, surrendering earlier gains and extending the turbulence that has gripped financial markets for much of this year.
The S&P 500 closed down 1.5 per cent, after being up as much as 1.5 per cent prior to the Fed’s afternoon decision. Similarly, Canada’s S&P/TSX Composite Index closed down 1.1 per cent, surrendering an earlier gain of 0.9 per cent.
“As I always say, markets may be efficient but that doesn’t insure they are rational. In this case, the knee-jerk reaction made little sense given that the Fed indicated it was optimistic about growth,” Joel Naroff, president and chief economist at Naroff Economic Advisors, said.
The currency market also reacted. In late afternoon trading, the Canadian dollar fell to 74.1 cents against the U.S. dollar, marking its lowest level in 18 months, as investors rushed into U.S. dollars.
The rout that followed Wednesday’s decision extends a rough patch for financial markets that may be suggesting a possible downturn in corporate profitability and economic activity. The S&P 500 is down 14.5 per cent from its record high in September and is on track to post its worst annual performance since the financial crisis in 2008.
Bond yields have also retreated from recent highs as growth and inflation expectations have ebbed. The yield on the 10-year U.S. Treasury bond declined to an eight-month low of 2.77 per cent, down from a seven-year high of more than 3.2 per cent as recently as November. The Government of Canada five-year bond, which influences fixed-mortgage rates, slipped to 1.89 per cent, down from 2.49 per cent in October. The yield is back to where it was near the start of the year.
The gyrations suggest that financial markets are expecting gloomier days ahead, and some investors may be disappointed that the Fed’s rate hike on Wednesday and forecast for further hikes fail to acknowledge the changing outlook.
The Fed’s monetary-policy decision was one of the most anticipated economic events in recent years, and U.S. President Donald Trump’s unorthodox call for the central bank to “feel the market” and hold off on a rate increase this week only raised the dramatic tension.
“Political considerations have played no role,” Fed chairman Jerome Powell said during an afternoon press conference. “Nothing will deter us from doing exactly what we think is the right thing to do.”
The Fed raised its key rate by a quarter of a percentage point, taking the target rate to a range between 2.25 per cent and 2.5 per cent. The increase, which was widely expected by economists, marks the fourth rate hike in 2018.
But in a notable shift, and a potential acknowledgment that financial markets may be reflecting concerns over the current quarterly pace of hikes, the Fed lowered its expectations for rate increases in 2019. Fed officials now see the need for just two increases next year, rather than the three increases it anticipated when it last published its expectations in September.
It also tempered its outlook for U.S. economic activity next year. It is now forecasting that growth will slow to about 2.3 per cent next year, down from a rosier forecast of 2.5 per cent growth.
In its accompanying statement, the Fed added that it “will continue to monitor global economic and financial developments,” possibly addressing concerns that the central bank had grown too rigid in its view that more rate hikes were necessary to get to what it sees as a neutral level, where interest rates neither stimulate nor slow economic activity.
“Critics opposing a hike today, who pointed to the malaise in equity markets, or the weakness in global growth indicators, can’t say that the Fed was tone-deaf to those concerns,” Avery Shenfeld, chief economist at CIBC World Markets, said.
While the U.S. economy is expanding at a brisk clip right now, many economists expect that this rate of expansion will slow significantly next year due to continuing trade tensions with China, the full absorption of last year’s U.S. tax cuts and the impact of prior rate hikes.
The flat yield curve – or the relatively minimal difference between the yields on short-term and longer-term bonds – suggests a skeptical view of economic activity that some observers believe is consistent with a coming recession.
Canada’s financial markets have been caught in the turmoil, underscoring the country’s sensitivity to the U.S. economy and weaker commodity prices.
The S&P/TSX Composite Index is down 12 per cent this year, touching its lowest point since July, 2016.
Now that the Fed has signalled its direction on monetary policy, the Bank of Canada’s own rate policy will be in economists' crosshairs, given the weaker state of the Canadian economy right now.
Canada’s rate of inflation fell to an 18-month low of 1.7 per cent in November, down from 2.4 per cent in October, with tumbling energy prices largely to blame, Statistics Canada said Wednesday. Capital Economics expects that inflation will likely move even lower early next year, to about 1 per cent.
"We do not expect any further interest rate hikes from the Bank of Canada,” Stephen Brown, senior Canada economist at Capital Economics, said.