To no one's surprise, the Federal Reserve hiked its target interest rate by 25 basis points on Wednesday. However, this meeting gave us plenty to unpack, including a new set of economic projections, a new dot plot, and a press conference by Chair Jerome Powell.
Here are my thoughts on where the Fed stands, what to expect over the next few meetings, and how you might position your portfolio.
There isn't a ton of great information to glean from the press release, as not a lot changed. The headline is that the Fed dropped the whole "stance of monetary policy remains accommodative" sentence, but that was inevitable at this point.
One big-picture point is worth mentioning. The Fed has described risks to the economy as "balanced" since late 2016, but this belies how the central bank feels.
It describes economic activity as "rising at a strong rate," unemployment has "stayed low," both consumer spending and business investment have "grown strongly." These descriptors just don't mesh with economic risks as "balanced."
It is more accurate is to say that while the economy is hitting on all cylinders, there are no obvious signs of inflation pressure, so the Fed isn't compelled to hike faster. But it is compelled to keep hiking.
Summary of Economic Projections (SEP)
Among the high-level economic forecasts, there were very few notable changes. Since we are already late in the year the 2018 projection doesn't really matter, it is best to look at 2019 and 2020 forecasts. Compared to their June projection, GDP, unemployment, and Core PCE inflation were basically unchanged for those two years.
Probably the most important part of this section is that the Fed is projecting unemployment to be 3.5% through 2019 and 2020, whereas their "Longer run" estimate is 4.5%. I'd interpret that as meaning that unemployment is going to be 1% below the natural rate that whole time. If in fact that happens, the Fed will be continuously hiking through that whole period.
Another important point is that historically, unemployment doesn't just get to a certain level and hang there. Historically it is almost always either rising or falling. In other words, if the economy is growing, unemployment is falling. If the economy is slowing, unemployment rises. Indeed, the only times you can find two-year periods where unemployment just hangs around the same level is as the cycle is turning. The last two times it happened, i.e. 24 months where unemployment stayed within a 0.5% range, was November 2007 and March 2001, were just before recessions began.
Anyway, in theory, if the Fed had exactly the right policy level, the economy would become perfectly balanced. In such a world, maybe unemployment could stay steady for an extended period. But what are the odds the Fed gets the policy level exactly right? Perhaps this is why it is projecting unemployment to rise in 2021?
The Dot Plot
Technically, this is part of the SEP but it merits its own discussion. As I've been writing in my Real Money pieces for months, the Fed is likely to keep hiking until it has done damage to the economy. It is not likely to pause at all until it sees signs of economic softness. By then it will probably be too late.
The median of the dot plot suggesting the Fed will hike one more time in 2018 is a slam dunk. The median dot then suggests three more hikes in 2019 (which would put us at a 3.00-3.25% target range), then one more in 2020. The medians for 2019 and 2020 are unchanged from June, although in the case of 2019, there is less dispersion. Notably, in the case of 2020, there is more dispersion. Even more interestingly, 2021 (which is a new projection for this meeting) is all over the map. Some members have a higher dot in 2020 than 2021, meaning they expect to cut in 2021.
Now let me emphasize, the dots are interesting in terms of divining how the Fed is thinking, but they shouldn't be seen as a real prediction. The reality is that rate-hiking decisions will be made in the moment. Hence, I continue to recommend assuming that as long as unemployment is falling, the Fed will hike around once per quarter. How long that lasts just depends on how long the expansion continues.
There wasn't anything earth shattering in the presser but here are two things I think you should bear in mind. First, Chair Powell seems very sanguine about the risks of trade to the economy. He basically said he isn't seeing any impact in the data. This means the Fed isn't going to pause and wait to see the effect of tariffs. Again, if unemployment is falling, the Fed is hiking.
The other interesting point is on financial stability. Powell called financial stability "the most important lesson from the financial crisis." How does that inform policy today? It suggests he's going to want to move in a methodical and predictable way as the Fed is tightening.
It also means the central bank is going to consider things like easy credit conditions and high P/E ratios as a sign it should keep hiking. I think this point leads us to a similar place as the first: The Fed wants to keep hiking and will do so until there is evidence that they've done damage.
I have three ways to position for more Fed hikes in 2019-2020 than the market has priced in.
1. Short 5-year Treasuries. This is the part of the yield curve most vulnerable to additional rate hikes. You can do so with an ETN such as iPath US Treasury 5-year Bear ETN (DFVS) or an ETF like iShares 3-7 Year Treasury Bond ETF (IEI) . I'm using 5-year futures.
2. Long longer-term bonds.This might seem weird given that I think the Fed keeps hiking, but if you pair it with the first idea, it is really a bet on the curve continuing to flatten. Although today the curve is flatter, we've actually been steepening for most of September. My bet is that the curve inverts sometime in 4Q 2018 or 1Q 2019. For this part of the trade I like an ETF such as iShares 20+ Year Treasury Bond ETF (TLT) or Long Bond futures.
3. Long USD. The dollar will rally if the Fed hikes more than is priced in now. Right after the Fed announcement, the dollar dropped, but has recovered all its losses on the day. I'm using the WisdomTree Bloomberg U.S. Dollar Bullish ETF (USDU) to be long the dollar.
This column originally appeared Sept. 26 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.