What if the Federal Reserve doesn't hike rates?

The US Federal Reserve is likely to raise interest rates by 25 basis points this week, but the bigger question is whether this will be the start of a rate-hiking cycle, according to Ed Yardeni, President of Yardeni Research. Markets are already pricing in two to three rate hikes over the next 12 months, with the two-year Treasury reflecting expectations of higher rates.

Yardeni believes investors should take some money off the table and keep cash ready as oil prices, bond yields and central bank policies create risks for US equities. While he remains optimistic about the long-term trend for US stocks, he expects cheaper valuations to become available.

This is an edited transcript of the interview.

Q: Let’s begin with the US markets, the macros. Is a rate hike already in the bag and in the price for this week?

A: There’s no celebration or party here in the United States. Everyone’s expecting that the Fed will, in fact, on Wednesday, September 16, announce a 25-basis-point increase in the federal funds rate.

The question is going to be whether it’s one and done, or whether this is the beginning of a rate-hiking cycle. And I think the press conference that Fed Chair Kevin Warsh will give after the FOMC meeting on Wednesday will be very important in terms of influencing the market’s perceptions of that.

But there’s a good chance that the market is already thinking that it’s not going to be one and done. The two-year Treasury right now is anticipating two, maybe three rate hikes over the next 12 months or so. That’s the same thing that we’re seeing in the futures market.

Q: We started the year expecting a couple of rate cuts, and that’s moved in the opposite direction, from maybe 50 to 75 basis points of rate cuts, to now looking at probably 50 to 75 basis points of rate hikes in the next 12 months or so. But what if they don’t go ahead and hike rates? If you look at the future, it’s pricing in a 90% probability of a rate hike. What kind of a message will it send? And in that kind of scenario, what kind of reaction would you see?

A: It’s almost inconceivable when you have the markets so convinced that the Fed’s going to raise rates. If they don’t do it, I think you’ll see bond yields spike to the upside.

I think not only the 10-year and the 30-year will spike up, but so will the two-year. I coined the expression bond vigilantes back in 1983. And so, if the Fed doesn’t turn vigilant here about inflation, then the bond vigilantes will do the job, and we don’t want to see that happen.

So, Fed Chair Kevin Warsh has said that he’s going to take his guidance from the markets. Well, the markets are screaming that rates need to go higher, and so we’re going to get a quarter-point hike. It’s inconceivable to me that that wouldn’t happen.

Q: So, you’re saying from an equity market perspective, you’d rather see a rate hike rather than no move from the Fed, isn’t it?

A: Yeah, absolutely, because I really don’t want—I’d rather have law and order established by the Fed than by the bond vigilantes.

Q: What about the potential of AI slowing down from here on? What kind of impact will it have on equity markets? Because the earnings growth in the US has been driven by AI spending, capex. Is there a potential that slows down, and when you couple that with tighter financial conditions over the next 12 months, is that going to hurt the earnings story for the US markets and the equity market trajectory?

A: Earnings is really what’s been driving the bull market. As a matter of fact, I kind of coined another term, and that is FEMO, Fabulous Earnings Momentum. Earnings have been remarkably strong, and so strong that investors almost can’t believe them, and so the valuation multiples have gone down as earnings have gone up, but earnings have gone up more than the valuations have gone down.

So, we still have had a bull market up to now, but certainly the scenario you lay out is a concern.

I don’t know about you, but my head is spinning from AI. What are we rooting for now? Do we want AI to just continue at that fast pace that it’s been on, or do we want it to slow down?

I think some investors have been saying they’d like to see things slow down so much, not just because of the concerns about the safety of AI, but simply because it’s been too much, too fast, and too much pressure on the labour market, too much pressure in the capital markets.

So, I think the data centres are still going to continue to be built. They’re really talking about putting some guardrails around the AI models. I don’t think when they’re saying slow it down, I don’t think they’re really talking about slowing down capacity expansion.

Q: What about the Bank of Japan? That’s the other big meeting that we’re looking forward to later this week. What are you expecting out there?

A: Japan has been sort of the poster child for ultra-easy monetary policy for a very long period. So long that hedge funds around the world kind of viewed Japan as a very cheap source of funds to borrow, and then they’d borrow the money in Japan at near-zero interest rates, convert the yen into other currencies, and buy bonds in other currencies where the bond yields were higher, like in Brazil, or the United States, or other parts of the world.

So, we may be seeing some unwinding of the so-called carry trade. Hedge funds may be starting to realise that the cheap-money days are over, in terms of what you can borrow in Japan.

And meanwhile, the stronger yen is also unwinding that carry trade.

And I think a lot of this bond pressure has been related to a kind of reversal of everything that’s been going on during the abnormal period between the Great Financial Crisis and the Great Virus Crisis, when central banks were basically rigging the fixed income markets.

Now the fixed income markets are free to vote, and they’re voting for higher rates.

Q: You’ve been quite bullish on US equities per se, but with the kind of cues that we have right now—a couple of rate hikes coming from the big central banks across the globe, crude oil prices that have spiked up, and sudden calls for some slowing down in AI, which actually has been a part of the market that’s helped earnings as well. Put all this together, do you think it’s time now to get a little bit cautious on equities?

A: I think it is. I tend to be an optimist, but more importantly, when you’re investing, you need to be a realist.

Optimism works on a trend basis. The long-term trend for stock prices in the United States has been to the upside, but occasionally you do have periods where there’s downside.

Watch the full conversation here

The question is: are they buying opportunities? Often, they do turn out to be buying opportunities. But I think this time around, I would take some money off the table, have some cash around, because there will be cheaper values available.

And I think this problem with oil, with bonds, with central bankers is going to persist and be a problem for the market.

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