By: Kent Engelke | Capitol Securities

Are the equity markets now rewarding tighter monetary policy? About 14 months ago, following the first increase in interest rates in about eight years, I opined the Federal Reserve just gave the “all clear signal.” Equities however were crushed during the following eight weeks, a rout that ended in mid-February 2016.

I had postulated a major reason for the considerable selloff was cross correlated and algorithmic trading as interest rates are a primary component of most valuation formulas. I also stated that any time since 2010 when there was any hint of a change in monetary policy, equities fell.

Fast forward to today. According to Fed fund futures, there is now an 80% chance of an increase in interest rates at the March FOMC meeting and for the first time since at least 2007, the market has fully discounted proposed Fed policy which is three interest rate hikes for the year.

As evidence to this view, I point to not only Fed funds futures, but also to the two-year treasury or the instrument most sensitive to monetary policy. The two-year treasury at a 1.31% yield is at the highest level since 2009.

There are several reasons for the radical change in the market’s expectations of monetary policy. Foremost is the PCE deflator, or a primary inflation indicator of the Federal Reserve. Currently it is at 1.9%. The FOMC’s mandated speed limit is 2.0%.

In every dimension monetary policy is extremely simulative, suggesting the overnight rate should be between 2.75% and 3.25% versus today’s current rate of 0.5%. Stating the overnight rate can rise to 1.25% is not superlative. In fact, such a level is still considered extremely simulative.

Equities have been strong since the election, predicated upon tax and regulatory relief, smaller government and infrastructure spending. I will also add I believe there is a complete breakdown of cross correlated trading which caused many sectors of the markets to plunge from June 2015-February 2016.

At some juncture, higher interest rates will impact the markets, especially the largest capitalized momentum issues that everyone owns because of the proliferation of ETFs and index funds. Moreover, the valuation of these issues can further become challenged because of the change in the geopolitical and macro-economic environment from globalism to nationalist economics.

What will happen today?

Last night the foreign markets were mixed. London was down 0.05%, Paris up 0.24% and Frankfurt up 0.05%. China was down 0.52%, Japan up 0.88% and Hang Sang down 0.20%.

The Dow should open flat. The 10-year is off 5/32 to yield 2.48%.