Investors should underreact to market overreactions

David Kelly, Chief Global Strategist at JP Morgan Asset Management, provides his perspective on how investors should respond to a likely rate hike by the Federal Reserve this week

On Wednesday, the Federal Reserve will likely finally raise interest rates from zero in an economy which should long ago have been taken off bedrest.

They will presumably achieve this by raising the interest paid on reserves to 0.50% and by utilizing the reverse repo facility to put a new floor of 0.25% under over-night rates.

Markets may well react badly to this – the first signs were perhaps the widening of spreads in the high-yield market last week. However, for investors, it is important to underreact to market overreactions and instead keep an eye on Fed messaging, economic fundamentals and financial market valuations.

With regard to messaging, there is considerable uncertainty about how the Fed will characterize future moves. In an ideal world, the “dot plot” for 2016 wouldn’t move much and would continue to point to four rate hikes next year.

However, there is a considerable risk that the current, very-dovish FOMC will seek to further soften the blow of a rate liftoff by reducing the projected number of rate hikes next year. In addition, it would not be surprising if Janet Yellen in her press conference emphasizes the possibility that the Fed could halt or reverse the tightening move in 2016 if economic conditions worsened.

Financial markets could react strongly to any further display of Fed dovishness. The dollar, which has risen by more than 20% from its 2014 lows in anticipation of Fed action, could well retreat in the face of Fed vacillation.

Long-term bond yields could fall further on a bet that something will convince the Fed to abandon tightening next year. The stock market could also be hurt if Fed communications seem to add to rather than reduce uncertainty.

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