The Fed And Fiscal Uncertainties

Brian Selzer

OCEAN CITY — With the Fed not hiking interest rates last week, we think it will remain patient and adopt a long and slow hiking cycle in response to an improving economy and therefore investors should focus more on the pace of interest rate hikes than on the date of the first hike.

Nevertheless, market volatility will be with us for a while and diversification with a focus on high quality is equally important for bonds and stocks.

The Fed’s monetary policy objectives are maximum employment and stable prices — often referred to as the dual mandate. The Fed would like to see continued improvement in the labor market and inflation of 2% before it embarks on an interest rate hiking cycle. However, inflation is lower than expected and recently increased market volatility has introduced uncertainty about the timing of the first Fed hike. According to BofAML Global Research, three scenarios seem plausible for the Fed: the base case is that markets stabilize and the Fed hikes this month; the second most likely scenario is that the Fed remains uncomfortable with market uncertainties and delays hiking until October or December; and the least likely scenario is that shocks to the economy worsen, damaging growth and turning a temporary delay into a semipermanent delay.

The Fed has to take all this into consideration when deciding whether to hike. We think the Fed will remain patient and adopt a long and slow hiking cycle in response to an improving economy. Interestingly, the market has already priced in an extremely gradual hiking cycle this time around, compared to staircase-like cycles in the past.

Economic policy uncertainty has been relatively low recently, but looks likely to increase over the next couple of months. Policy uncertainty last spiked around the federal government shutdown and debt limit debate in October 2013, and has been fairly subdued since then. With another series of deadlines approaching, including the end of the federal fiscal year and another debt limit deadline, headlines out of Washington are likely to lead to an uptick in uncertainty, at least temporarily.

Lawmakers face four important deadlines over the next few months: 1. Congressional consideration of the Iran nuclear agreement.

  1. Fiscal year-end (Sept. 30): There is a greater risk of a federal government shutdown from Oct. 1 than there has been at any point since the last government shutdown occurred two years ago. However, it is the view of BofAML Global Research that, going into an election year, incentives are strong to avoid “fiscal cliffs” that create uncertainty and undermine confidence.
  2. Transportation infrastructure funding expires (Oct. 29): After a series of short-term extensions, many in Congress hope to pass a long-term (five- to six-year) reauthorization of the federal highway program, but lawmakers have not been able to agree on how to offset the cost of doing so.
  3. The debt limit will probably need to be raised in November: The U.S. Treasury has indicated that the extraordinary measures employed to preserve the nation’s borrowing capacity are not likely to be exhausted before late October and will last for at least a brief additional period of time. According to Strategas, an independent research firm, the debt ceiling will need to be raised sometime between mid-November and early December.

(A Merrill Lynch Wealth Management Advisor who can be reached at 410-213-8520.)

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