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Fed takes a leisurely hike, but path set to steepen
As expected, the Federal Reserve’s Open Market Committee (FOMC) raised the target federal funds rate by 0.25%, to a range of 0.5%-0.75%. The FOMC’s projected policy path now calls for three rates hikes next year, compared to just two when they last made their forecasts public in September. The statement accompanying the decision, which was unanimous, did not deviate materially from prior versions, maintaining a pledge to keep the path of rate increases “gradual” and data-dependent. The one notable change was an acknowledgement that market-based measures of inflation expectations had increased materially since the last time the committee met.
Despite the Fed’s pledge to continue only a gradual path of rate hikes into next year, financial markets interpreted the overall message as more hawkish than anticipated. The U.S. dollar strengthened broadly, hitting its strongest level against the Japanese yen since February. The 10-year U.S. Treasury yield rose from 2.44% just before the meeting’s conclusion to over 2.57%, its 2016 high, in afternoon trading. The S&P 500, which had been flat for the day prior to the statement, fell immediately following the announcement but managed to close the day off its lows, dropping 0.8%.
Coming into the meeting, markets were most interested in: 1) whether the Fed would back away from the cautious language around rate hikes that has characterized recent Fed communication; and 2) what Chair Janet Yellen might have to say in her press conference regarding the Fed’s response to likely fiscal stimulus next year. There was little change on the first point, despite the expected number of hikes rising to three from two. On the second point, Yellen was careful to avoid wading into the policy agenda for the incoming Trump administration and Congress. She noted that while fiscal policy expansion was no longer needed for the U.S. to reach full employment, changes in fiscal policy that improve productivity and boost investment might still prove helpful. She also demurred when asked about the prospects for her reappointment to a second term when her first expires in January 2018.
Overall, market adjustments were generally modest following the meeting, and for good reason. This move was widely expected and had been priced in for weeks. The 2-year U.S. Treasury yield, most sensitive to changes in near-term monetary policy, had already risen over 60 basis points from its bottom in July before increasing another 10 basis points after the meeting. The move over the past few weeks reflected not only increased certainty that Wednesday’s hike would occur, but also firming expectations about a steeper path of tightening from here. The Fed seemed to confirm the markets’ interpretation.
The larger question for investors is whether the current market and Fed expectations for monetary tightening can be consistent with a further rise in the U.S. equity market. Despite the modest drop in stocks on Wednesday, we believe the answer is yes. Elevated volatility is common around monetary policy changes, but during the previous tightening cycle from 2004 through 2006—a rapid one by today’s standards, in which rates rose from 1% to 5.25%—the S&P 500 returned a cumulative 30% on rising corporate earnings. Of course, U.S. stocks are moderately more expensive today than they were at the start of that period, which should temper the comparison somewhat.
Fixed-income investors felt another day of pain on Wednesday, with rising interest rates continuing to provide a stiff headwind for total returns on bond portfolios. Nevertheless, we believe with every rate hike, the case for holding fixed income improves. But we also acknowledge that investors may not fully appreciate the benefits of higher rates unless and until rates are done rising. This means a few more challenging years may lie ahead.
Lastly, the continued upward move in the U.S. dollar is worth watching, as it threatens the competitiveness of U.S. companies and—given the concerns it has spawned about Chinese currency and economic policy over the past 18 months—is prone to causing panic selloffs in global equity markets. We don’t expect to see much further dollar appreciation from here, as the market and the Fed now agree with our forecast for three rate hikes in 2017. Investors should regard the strong level of the dollar as a sign that international assets, particularly stocks, look more attractive than they have for quite some time. Increased competitiveness and an advantageous foreign-exchange entry level for U.S. investors contribute to our case for making international equities, both developed and emerging, our preferred asset classes for the next 12 months.