As expected, the Federal Reserve left its interest rate target alone after its FOMC meeting concluded Wednesday. However, the press release does make clear the central bank intends on moving forward with a rate hike in September, and probably December as well. Here are my thoughts and some updates on the trades I favor.
In Fed Chair Jerome Powell's Congressional testimony a few weeks ago, he inserted the qualifier "for now" in describing the Fed's rate hiking plan: "The FOMC believes that -- for now -- the best way forward is to keep gradually raising the federal funds rate" (emphasis added).
I wrote at the time that I didn't think this statement meant much. He was probably just making sure the Fed kept its options open for future meetings. Others thought this was a purposeful hint at a pause coming after 1-2 more hikes.
I think Wednesday's press release confirms my suspicion. If the Fed had wanted to communicate the likelihood of a pause it could have repeated this phrase (or something similar) in the official statement. Instead it described economic growth as "strong," which certainly doesn't portend any kind of near-term pause.
What Is Priced In?
The market has fully priced in a hike for September. The odds of a second hike in December are around 75%. This was more like 50/50 at the end of May but has been steadily rising.
After that, the market has two more rate hikes kind of vaguely priced in for the rest of 2019 and then it flatlines from there. There is zero chance it actually happens that way.
So What Will Happen?
Here's the way I'm thinking about it. The Fed is definitely hiking in September, and barring some shocking downturn in the next four months, the central bank will be hiking in December, too. After that it depends on what the economy is doing. However, my base case is that as long as unemployment is steady or falling the Fed will probably hike at a 1x per quarter pace. It almost doesn't matter what other indicators are doing, excluding something really shocking.
In essence, the Fed is going to assume that as long as the labor market is tight, policy is still on the accomodative side. If that's true, it is going to want to keep hiking. Or put another way: The Fed is going to keep hiking until it's done damage. Of course, by then it will be too late, but that's what's probably going to happen.
What Does This Mean for Markets?
-- Intermediate-term, it's tough for stocks: I don't know for sure how many rate hikes the Fed can do before it has "done damage." Gun to my head, I'd guess its two to three more before the economy starts to feel the pain. If that's true, 2019 is probably a rough year for stocks. There are two ways I'm wrong. First, the economy can just handle more hikes than I think, which is entirely possible. Second is that the Fed somehow threads the needle and pauses at just the right time. I'd put very low odds on that.
-- The curve will invert once the fed funds get to 2.5%: Measured from 2-10 year, the 2-year should be around 2.80-3.00% by that time, which I think would be enough to invert the curve on those two points. The only way this doesn't happen is if the economy seems to be slowing quicker than that, which would keep the 2's from continuing to rise. Of course, the curve could still invert if the 10's fell enough in that case. Either way, I still like the pair trade I've been suggesting: long 20-30 year bonds and short 3-7 year bonds. You can use the iPath U.S. Treasury Flattener ETN (FLAT) if you are so-inclined.
-- The dollar should keep strengthening: I actually like this trade a bit more now than I did a few weeks ago when I first mentioned it. People are way over-reading the Bank of Japan's recent move, and Europe already looks to be weakening. The dollar is the one currency showing unmitigated strength. I'm long WisdomTree Bloomberg U.S. Dollar Bullish ETF (USDU) personally.
-- Longer-term rates are attractive: It probably goes without saying given my bearish view of risk assets, but I don't see longer-term interest rates busting higher. Wednesday the 10-year is trading up to 3%, but it should see strong support at 3.02% and again at 3.11%. I don't know if this is the top of rates per se, but I'd much rather be long than short.
This column originally appeared Aug. 1 on Real Money Pro, our premium site for active traders and Wall Street professionals. Click here to get great columns like this even earlier in the trading day.