Hawkish Fed Stance: What It Means for Investors and Markets

Here is how the Fed’s hawkish stance will affect inflation and equities as investors assess the upcoming path of US monetary policy.

The Federal Reserve has given a warning that interest rates may need to rise if US inflation does not move toward its 2% target which has created a more hawkish outlook for monetary policy. Federal Reserve Chair Kevin Warsh gave this message at the Jackson Hole Economic Policy Symposium on August 28 and he made clear that price stability is a big goal and that policymakers cannot assume inflation will return to the target on its own.

How does a hawkish stance work?

A hawkish monetary policy stance means the central bank will give higher priority to inflation control even if higher rates put some pressure on economic growth and employment. The Federal Reserve has a dual mandate which covers maximum employment and price stability and its long-term inflation target is 2%. When inflation is too high then the Fed can raise interest rates because this will make borrowing more expensive and bring down inflation. Warsh also said policymakers have more work to do if they are not confident that underlying inflation is moving towards that goal clearly and quickly enough. Warsh did not make a specific commitment to raise rates at any particular meeting though. Future inflation and employment data will therefore be a critical aspect.

Why the jobs data matters so much

The next major test for the Fed will be the August employment report and this is especially important because July's data was unexpectedly weak. Economists polled by Bloomberg expect 50,000 jobs to have been added in August and also expect the unemployment rate to be unchanged at 4.1%. The figures will follow a surprisingly weak July jobs report which showed a contraction of 23,000 jobs. That left the Fed in a difficult position because a weak labour market usually supports the case for lower interest rates. If the August employment data will show that hiring has weakened then the Fed may need to assess how much more pressure the economy can absorb.

Market's reaction

Markets have already reacted to the change in tone from the Fed as the probability of a September rate rose a lot after Warsh's speech. Short-term Treasuries sold off because investors expected rate increases as soon as next month. The 2-year Treasury yield rose 11 basis points to 4.34% which was its highest level in a month. The 10-year Treasury yield increased 5 basis points to 4.72% and the 30-year Treasury yield rose to 5.206%.

What does a hawkish Fed mean for investors?

Higher interest rates generally create a tougher environment for risk assets as investors can earn more from relatively low risk assets such as government bonds. Companies also face higher borrowing costs when rates rise and growth stocks can be particularly sensitive to higher rates because much of their valuation will depend on profits expected several years in the future.

A hawkish Fed can therefore put pressure on technology stocks and highly leveraged companies. Real estate businesses and other assets whose valuations are especially sensitive to interest rates can also face pressure. Banks and financial companies can sometimes benefit from higher rates instead. Short-term bonds may also become more attractive to investors who focus on reliable passive income and safety. The US dollar can strengthen as well when markets expect higher interest rates because higher yields can increase demand for dollar-denominated assets. Another issue is the enormous debt burden of the US government as evident by the fact that investors now demand more attractive yields to hold long dated government debt. Concerns about US government debt therefore is an important source of pressure in the bond market.

(Source: Reuters and Financial Times)