By Robert B. Segal
Financial markets took a wild ride last year. As 2014 entered the home stretch, the plunge in the price of oil was the biggest story. Europe’s continued troubles and a slowdown in the Chinese economy muted the demand for oil. Meanwhile, the U.S. shale-oil boom and a rebound of drilling boosted supply. The result was the market producing many more barrels of oil a day than were consumed. As oil supplies ballooned, prices inevitably fell.
The uncertainty around energy caused overall market volatility to spike. A gauge of volatility across asset classes reached a 15-month high while more than $2.7 trillion was erased from the value of equities worldwide in less than a month. On the other hand, the price drop has stimulated the economy, with consumers saving hundreds of millions of dollars a day. In November, consumer prices in the U.S. fell by the most in six years, led by the plunge in fuel. Inflation in the euro area, meanwhile, is at a five-year low.
Against this backdrop, the Federal Reserve took a delicate step toward raising short-term interest rates. In a statement after the December Federal Open Market Committee (FOMC) meeting, the committee said it would be “patient” before raising rates, adding that the outlook hadn’t much changed from earlier assurances that rates would stay low for a “considerable time.” In a news conference following the meeting, Federal Reserve Chairman Janet Yellen reiterated that any decision will be “data-dependent.”
Fixed-income markets confounded most investors last year. Longer-term interest rates were expected to increase as the Fed wound down its third round of bond purchases. According to a Bloomberg survey taken in December 2013, the 10-year Treasury yield would rise to 3.37 percent by the end of 2014, an increase of 50 basis points from that point in time. The high point (3.05 percent) was actually reached on the year’s second trading day. Yields for the 10-year note fell gradually throughout the year on declining inflation expectations and steady foreign demand; the yield fell as low as 1.87 percent in intraday trading on Oct. 15.
Ironically, fixed-income securities most influenced by the Fed’s monetary policy, shorter-term notes, saw their yields rise. As an example, the two-year Treasury yield reached 0.77 percent on Dec. 23, a three-year high. Further out on the curve, the five-year Treasury peaked at 1.85 percent on Sept. 18. While the plunge in 10-year yields captured the public’s attention, benchmarks for bank pricing (two- and five-year), moved in the opposite direction.
A Bumpy Ride
Most expect the Federal Reserve to continue on the path of normalizing monetary policy. The end to quantitative easing was the first step; an increase in short-term interest rates during 2015 is the next one. Markets currently forecast the first of two 25 basis-point hikes will occur in late summer 2015 with two additional 25 basis-point hikes at subsequent FOMC meetings. This would leave the Federal Funds rate at 0.75 percent by the end of 2015. The Fed is expected to take a measured approach that may result in long pauses between incremental increases in short-term rate policy, at least initially.
The smallest budget deficit since 2008, a soaring dollar and yields on Treasuries that are higher than most developed nations in Europe and Asia will probably bolster demand at U.S. debt auctions, limiting the damage from any bond market selloff. There’s global demand for high-yielding, high-quality assets such as Treasuries, according to market watchers. Wall Street forecasters say longer-term interest rates should increase between 50 and 75 basis points throughout 2015.
Fed interest rate hikes may not be a problem for the market until part way through or late in the tightening cycle, although it promises to be a bumpy ride. The stock market often corrects within a 12-month period before the Fed’s first rate hike. The average correction has been about 15 percent in the 12 tightening cycles since 1971, although they were brief, usually lasting about three months. Despite the likelihood of selloffs, the market’s overall performance is usually positive over the three-, six- and 12-month periods leading up to the Fed’s first move. The equity market usually becomes vulnerable once the Fed has tightened enough to engineer a recession. While global central banks are likely to be less helpful to financial markets than during the past several years, they won’t put the hammer down in the coming year.
Wall Street’s analysts expect the Standard & Poor’s 500 stock index to rise 10 percent in 2015. That gain compares to 11 percent for last year and 2013’s 30 percent advance. The strategists’ 2015 targets for the S&P 500 range from a low of 2100 to a high of 2350, with a mean of 2208.
If the Fed maintains its policy of broadly telegraphing interest-rate moves, and if the federal-funds rate is lifted in a measured and orderly manner, the stock market can edge higher. At six years, the stock market rally is getting old. But recessions, not longevity, typically end bull markets. In a world of mild inflation and cautious central banks, don’t look for a sharp rise in Treasury yields either.