December 2018 has so far been one of the ugliest Decembers in U.S. stock market history. The S&P 500 declined 7.8% in 10 trading days and experienced the worst two-day selloff since October. Cheaper valuations, the U.S.-China trade truce, and dovish Fed commentary were not enough to put an end to falling stock markets. Santa Clause seems to have lost his way this year, defying hopes that stocks will rally towards the year’s end. Instead, institutional investors appear to be pulling out, taking whatever profits they have accumulated throughout this year.
Today the FOMC will kick off its highly anticipated two-day meeting. Given the steep decline in equities and the economic slowdown in Asia and Europe, many investors hope that the Fed will shelve the December rate hike. However, the U.S. economy grew an annualized 3.5% in the third quarter, unemployment is currently at a 50-year low, and inflation is near target. Given these factors, monetary policymakers won’t be able to justify a pause in the normalization cycle. In my opinion, avoiding a rate hike in December will send a negative signal to markets, confirming the views that a recession is about to hit the global economy.
Instead, the more probable scenario on Wednesday would be to deliver a dovish rate hike. This means the Fed will raise rates by 25 basis points and indicate that going forward, the policy will be data-dependent. Expect the phrase ‘further gradual increase’ to be dropped from the statement especially following Fed Chairman Jerome Powell’s remarks that the central bank's benchmark interest rate is ‘just below’ neutral. This will allow the central bank to pause the hiking cycle next year without causing shocks to expectations.
The Fed’s dot plot is another interesting chart to observe on Wednesday. In September’s meeting, Fed participants projected three rate hikes in 2019. Expect these dots to shift downwards to two hikes instead. Meanwhile, the longer-term interest rates may be dragged downwards to indicate that we’re getting closer to neutral rates.
Chairman Powell is likely to be faced with many questions about the threat of economic slowdown especially given the recent inversion of the yield curve. Investors will scrutinize every word he says, but I think at this stage there’s little he can do to provide equity bulls their much-needed confidence.