Greenspan’s Job Is Almost Complete

I believe the Fed will stop hiking rates at the 4.5% – 4.75% level.  All else being equal, the end of the Fed tightening cycle should allow the equity market to rise, similar to 1995. As long as oil prices remain in check and economic data remains steady, the market has one less obstacle if the Fed stops raising rates at the beginning of 2006.   

The Fed gave hints that it is close to being done raising rates in its recent Federal Reserve Board meeting.  In addition, I believe the Fed has accomplished one of its primary objectives in cooling the housing market, based on observations from the November Beige Book indicating the housing market has slowed.  The Fed has been explicitly targeting the housing market with its rate hikes. The fact that the housing market is beginning to taper off should allow the Fed to end its "measured pace" of rate increases.      

The Fed notes released last Wednesday revealed that several board members showed signs that they are considering a pause in interest rate hikes…

…Some members cautioned that risks of going too far with the tightening process could also eventually emerge. Nonetheless, all members agreed to indicate at the conclusion of this meeting that a continued measured pace of policy firming remained likely.

In their ongoing discussion of the Committee’s communication strategy, participants expressed a variety of perspectives about how the policy statement issued at the end of FOMC meetings might evolve over time. Several aspects of the statement language would have to be changed before long, particularly those related to the characterization of and outlook for policy. Possible future changes in the sentence on the balance of risks to the Committee’s objectives were also discussed. Participants noted that any forward-looking elements of the statement should clearly be conditioned on the outlook for inflation and economic growth. For this meeting, members concurred that the current statement structure could be retained, as it accurately conveyed their near-term economic and policy outlook.

I believe the Fed governors are contemplating a change in the statement because they have accomplished one of their primary objectives.  Namely, they have cooled the housing market.  In the November 30 Beige Book, the regional Fed banks noted the following about the housing market:

Real Estate and Construction

Residential real estate activity was reported to have moderated in many Districts…The Minneapolis District noted that, for the Minneapolis-St. Paul metro area, existing homes were on the market longer, inventories were rising, and price appreciation had slowed. Although home sales remained fairly strong in New York City, the New York District reported that overall sales of homes in New Jersey had slowed and inventories were high. Both the Chicago and Atlanta Districts reported flat home sales, and excess inventories were reported in the Kansas City District, though home sales there were up slightly…

…The pace of residential construction moderated in the Atlanta District, and homebuilders reported an expected slowing in the Philadelphia District; homebuilders also reported rising price of inputs in the Philadelphia, Cleveland, and Richmond Districts, as well as difficulties in obtaining some materials in the Kansas City District.

It’s worth the effort to try to anticipate the Fed’s actions.  In 1995, as the market was still hovering at the top end of the 18 month trading range, the market began discounting the end of the Fed tightening cycle.  Bearishness was rampant but alert traders realized that the market was breaking to new highs because investors were betting that the Fed was done raising rates.  On Feb 1st, the Fed raised the discount rate by 50 bps to 6%.  The next move didn’t come until July of 1995, when the Fed lowered rates by 25 bps.  By then, the market had already launched out of a strong base and was well into one of the greatest bull market runs in history. 

While I can’t predict another bull market run like in 1995, I believe traders need to anticipate the end of the tightening cycle.  Many bears are still betting that the Fed will overshoot on its tightening campaign and send the economy into a recession next year.  However, the clues indicate that the Fed is well aware of the risks of overshooting and is close to the end of the tightening cycle.