Two More Fed Hikes Could Trigger a Bear Market, Stifel Says

(Bloomberg) -- The Federal Reserve may trigger a U.S. equity bear market after two more interest-rate increases, according to the brokerage Stifel Nicolaus.

If expectations of two more Fed hikes in 2018 are correct, then an indicator based on the so-called neutral level for interest rates will cross a bear-market trigger point by the end of the year, strategist Barry Bannister wrote in a note to clients Wednesday. The gauge has signaled previous sell-offs in stocks in 2000 and 2007, he said.

Two More Fed Hikes Could Trigger a Bear Market, Stifel Says

“Although some say the neutral rate is difficult to observe, stocks see the barrier quite clearly,” Bannister wrote. “A ‘maximum tolerable peak’ for the fed funds above the neutral rate has been associated with bear markets since the late-90s global-debt boom.”

Bannister’s indicator combines an estimate of the neutral rate -- in theory the interest rate that neither stimulates nor holds back the economy -- with projections for the federal funds rate. The central bank’s long-term projection of its policy rate has risen from 2.8 percent at the end of 2017 to 2.9 percent in June. The median forecast of economists surveyed by Bloomberg has the Fed Funds rate reaching 3 percent by the end of the second quarter of 2019.

According to Stifel, the Fed faces the dilemma of going above neutral in 2019 to forestall late-cycle inflation or remaining below it and fostering speculative bubbles in financial assets.

“Weighing stability versus mandate, we believe the Fed has no realistic option other than to follow its projected dot-plot path, eventually revealing the speculative excesses created in the past decade,” he said.

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