The US Federal Open Market Committee (FOMC) has raised the Federal Funds Rate (FFR) by 0.25% to 0.5-0.75% by unanimous vote, in a move widely anticipated by markets.
FOMC chair Janet Yellen said the 25 basis point hike, only the second rate adjustment since December 2008, was in recognition of considerable progress the US economy had made toward its dual objectives of maximum employment and price stability, as well as its 2% inflation target.
Yellen said economic growth had picked up since the middle of the year with household spending continuing to rise at a moderate pace. Meanwhile, unemployment fell to 4.6% in November, its lowest level since 2007, and the 12-month change in the price index for personal consumption expenditures was nearly 1.5% in October – up more than a percentage point from a year earlier.
Both the dollar and US Treasuries rallied following the announcement, with the dollar trading up 0.5% to £0.79241 and two-year and 10-year Treasury yields hitting 1.24% and 2.52%, respectively. Meanwhile, the S&P 500 equity index dropped 0.5%.
Yellen said the economic outlook remained highly uncertain, but hinted the move was not in anticipation of future fiscal policy changes under Donald Trump’s presidential tenure.
She said it was far too early to know how policy would unfold; adding changes in fiscal policy are only one of the many factors influencing the outlook and appropriate course of monetary policy.
“In making our policy decisions, we will continue – as always – to assess economic conditions relative to our objectives of maximum employment and 2% inflation,” she said. “As I have noted on previous occasions, policy is not on a pre-set course.”
Looking ahead, Yellen said the median projection for growth of inflation-adjusted gross domestic product (GDP) is expected to rise to 2.1% in 2017 from 1.9% this year, and will hover around 2% in 2018 and 2019.
The median projection for the unemployment rate stands at 4.7% in the fourth quarter of this year and 4.5% over the next three years.
In terms of inflation, Yellen said the median inflation projection is 1.5% this year, rising to 1.9% next year and 2%, the FOMC’s long-running target, in 2018 and 2019.
Accelerated hiking next year
A rate rise was no surprise to asset managers and it had already been ‘baked-in’ to most asset prices.
Axa Investment Managers senior economist David Page said despite the market posting strong moves in the immediate aftermath of the decision, the announcement was “somewhat anti-climactic”. He said the largest “known unknown” was the detail of the next administration’s policies.
He added: “We have tentatively anticipated a focus on a corporate fiscal stimulus, with modest protectionism. Accordingly, we have raised our GDP forecast to 2.1% and 1.9% for 2017 and 2018 respectively. Growth in this vicinity is likely to see inflation pick up over the coming years, we estimate to 2.5% by 2018. Accordingly we forecast two rate hikes next year and three the year after (taking policy to 1.75-2.00%). This is softer than the Fed currently suggests.”
A bigger surprise for most asset managers than the rate hike was the Fed signalling a further three rate hikes next year through its 2017 “dot plot”, rather than the earlier forecast of two.
Old Mutual Global Strategic Bond fund portfolio manager, Nicholas Wall, said this was a “big surprise” which had seen curves bear flatten and the dollar strengthen.
However, he added: “Longer term, we would expect curves to steepen due to the large amount of ‘search for yield’ trades that still need to be unwound in the market and due to the prospect of the US running higher fiscal deficits, boosting nominal GDP growth that tends to influence the long end of the curve to a greater degree. This is a modest change, but a further step towards policy normalisation.”
Pioneer Investments head of investment management US, Ken Taubes, agreed the projection of a triple hike in 2017 was a surprise. However, he noted that Yellen emphasised this represented a modest change, driven by improving employment data, higher realised and expected inflation, and the consideration by certain FOMC members of potential changes in fiscal policy under a Trump administration.
He added: “What may be more interesting is that the FOMC economic projections did not reflect any significant changes from their September levels, other than the one additional rate hike in 2017. The projections were largely unchanged despite the dramatic post-Trump election rally in equity markets, and sharp increases in Treasury yields, inflation expectations and the US dollar.”
Cautious on global credit, optimistic on US small caps
Legal & General Investment Management portfolio construction associate – active liability solutions, Daniela Russell, said the Fed’s upward revision of rate rises had been underpinned by “encouraging” recent US domestic economic activity data.
She added while there was unlikely to be any precise detail on US fiscal policy before Trump’s inauguration in January, it was clear that some degree of fiscal loosening is on the agenda.
Russell added: “Nevertheless, the key risk to the current reflation trade is that credit conditions tighten faster than economic growth is improving. Therefore, given our concerns over the structural vulnerabilities associated with the global debt overhang, we believe it is prudent to remain cautiously positioned across global credit portfolios.”
Hermes Investment Management lead portfolio manager, US small and mid-cap, Mark Sherlock, observed that a direct effect of higher short-term rates is a further increase in long-term bond yields, which had risen in expectation of the decision, and will help improve the profitability of regional banks.
“More broadly, US small caps typically outperform large caps during interest-rate tightening cycles as they are more heavily exposed to domestic growth,” he added. “From 1963 to 2012, small companies generated an average total return of 13% in periods when interest rates rose, compared to the 8.1% return from large companies.”
Pioneer’s Taubes meanwhile, said the firm continued to be positioned for rising interest rates and inflation in the wake of a stronger economy.
“We prefer credit markets over US Treasuries,” he added. “Corporations may benefit from lower taxes, less regulation and higher growth. Within corporates, we favour financials and energy.
“Long-duration TIPS are attractive, in our view, given that breakevens (a measure of TIPs prices vs. Treasuries factoring expected inflation) embedded in TIPS are too low. Inflation expectations may continue to rise, reflecting higher spending, accompanied by potentially higher US debt levels. Higher yields, better relative economic growth and diverging monetary policies may continue to favour the US dollar; we have become more cautious on non-dollar exposures.”
With regard to equities, Taubes said cyclicals may continue to outperform staples, as they should benefit from improving economic growth, and he also favoured technology and financials.
