Every quarter, WisdomTree Investments holds a quarterly review and outlook conference call with Senior Investment Strategy Advisor, Wharton Professor Jeremy Siegel, where listeners can submit questions ahead of time and help drive the content of the call. In this series of blog posts, WisdomTree reviews the most pressing economic and market issues that were discussed during this quarter’s call.
Question to Professor Siegel:
Given your academic training was in monetary policy, let’s start with the U.S. Federal Reserve’s interest rate policy. Do you think the Fed interest rates will remain at these historically low levels until the middle of 2015, as is currently projected?
Professor Siegel’s Answer:
The Fed’s pledge is to keep its policy rate target at 0 to 25 basis points until the middle of 2015. The trigger mechanism was specified to be dependent on the unemployment rate and inflation, but Bernanke was very careful to say that according to the projections of the Federal Open Market Committee (FOMC) members on unemployment inflation, that did coincide with the middle of 2015.
I keep close track of the Fed funds futures market. I have noticed that December Fed funds futures have jumped to over 30 basis points—up three-and-a-half basis points. That’s a rather big move for Fed funds futures. This means a number of participants expect a stronger economy than the Fed anticipates, which would force them to tighten credit before the mid-2015 date. Now this is preliminary, and we have to admit we have had false starts before, where we saw strength early in the economy only to watch it peter out in the middle of the year.
But I think that this year’s economy will be stronger than expected, with gross domestic product (GDP) growth of 3% or higher rather than the 2% of consensus estimates. I think the stock market senses that—it has matched and exceeded its September 2012 highs that it reached before the fiscal cliff concerns.
So yes, I do think that interest rates will rise sooner than 2015.
A lot of people are starting to worry that if interest rates rise, this could put an end to the bull market we’ve been experiencing. Is that something you’re concerned about?
Professor Siegel’s Answer:
At the end of a Fed tightening, there should be concern, but never at the beginning of a Fed tightening. One has to remember that the only reason the Fed would be tightening would be because it sees a stronger economy. And that is good for earnings. Stock prices are dependent on two major variables: future earnings1 and the rate that you discount those earnings2. If we see the interest rate rising, it will be only because we see a stronger economy, which will boost earnings. And one should also note that if we see a stronger economy, that will tend to lower the risk premium that investors demand of stocks and provide further support to prices.
When I look back at history, I believe it really takes anywhere from nine months to two years after the beginning of a tightening before stocks can run into problems. I don’t think we should be worrying about the end of a bull market now. It’s way, way too early. And don’t forget—we have been at the rock bottom of interest rates. Raising rates to 2% and 3% would just be a normal level from which the Fed would operate. So I’m not concerned about the Fed’s initial tightening being a problem for this market.