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In the Federal Reserve's October press release, the central bank changed one important word in its latest policy statement. In their focus on the rate decision, most investors probably didn't notice the other announcement. In its prior update, the Fed said that economic activity was expanding at a "solid" pace. Now, it's expanding at a "strong" one.
It might sound like a throwaway change to a sentence. But the Fed words these statements carefully. This wasn't a mistake or an oversight. Since it raised rates once already this year, this could be interpreted as a signal.
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Earlier this year, the market expected it wouldn't have to deal with rate hikes until well into 2027. A big reason stocks experienced a broad rally at the start of this year was expectations of a lack of Fed action.
The Iran war changed all that. Oil prices took off, inflation moved well above 3% annually, and the Fed decided to hike rates at the September meeting. Long-term bond yields soared, and the 10-year Treasury briefly touched 5.31%, its highest level since 2007. Currently, the futures market is pricing in a greater-than-70% chance of another rate hike at the December meeting and two more hikes in total by the June 2027 meeting.
Then came the inflation data. The BLS reported that the annual inflation rate jumped to 3.7% in September. Gas prices jumped 9.1% that month alone and were up 34% year over year. While you could argue that rate hikes may not do much to address a geopolitically induced oil shock, there's little justification for the Fed to hold given the full picture.
But the one thing that might make the strongest case for a rate hike is U.S. economic growth. The first read on third-quarter GDP came in at a 3.4% annualized growth rate, up sharply from 2.2% in Q2 and beating estimates of 3.2%.
This is the kind of number that the Street will look at and wonder whether the economy is getting too hot. When the economy grows too fast, it tends to eventually push inflation higher as well. But we're already at a much-above-average inflation rate. If economic growth continues to accelerate at this pace, it's likely to put pressure on inflation to rise even further.
Fed Chair Kevin Warsh is justified in "upgrading" the state of the economy from "solid" to "strong." GDP growth numbers support it, even though consumer sentiment is low and affordability issues are widespread. In his statement, Warsh acknowledged that inflation is "too high," and together, everything would suggest that at least one more rate hike is coming. And it's probably coming soon.
If the Fed decides to hike rates again, that will push short-term Treasury rates higher too. The WisdomTree Floating Rate Treasury ETF (NYSEMKT: USFR) would be one of the most direct ways to play rate hikes in your portfolio. It invests in short-term floating-rate Treasuries, so its dividend yield should adjust relatively quickly to any Fed moves.
We've also seen equities react pretty consistently to changes in rate expectations. Anything that raises the possibility of a Fed rate hike is usually a negative for U.S. stock prices.
Unfortunately, strong GDP growth in this instance becomes a double-edged sword. It's good to have the economy growing. But if it grows fast enough, the Fed will likely take steps to slow it down to keep inflationary risks in check.
As long as inflation remains elevated, the Iran war rages on, and the U.S. economy keeps printing 3% growth rates, investors should plan on a potentially challenging environment for equities.
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David Dierking has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.
With Only 1 Word, The Fed Just Sent an Important Message to Investors was originally published by The Motley Fool
