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Fed Raises Rates, Projects More to Come in 2018

By Collin Martin /article #node

December 13, 2017

As expected, the Federal Reserve raised the target range for its benchmark interest rate by a quarter of a percentage point at its December meeting, to a range of 1.25% to 1.5%. The increase in the federal funds rate—the rate banks charge each other for overnight loans—was widely expected by the markets.

However, the vote wasn’t unanimous: Minneapolis Fed President Neel Kashkari and Chicago Fed President Charles Evans both preferred to leave the rate unchanged.

The statement issued by the Federal Open Market Committee (FOMC), the Fed’s monetary policymaking arm, painted a relatively upbeat outlook of the economy. After all, U.S. gross domestic product (GDP) rose by more than 3% in both the second and third quarters of this year, and surveys from both consumers and business show sentiment is high. The FOMC statement said the “labor market continued to strengthen and that economic activity has been rising at a solid rate.”

Despite the positive outlook on the economy, most inflation indicators remain below the Fed’s 2% target. Consistent with previous statements, the FOMC acknowledged that inflation may remain low in the near-term, but should rise toward the Fed’s 2% target over the medium term. The committee also noted that the hurricanes that hit in recent months hadn’t materially altered the outlook for the economy.

There was no mention of the Fed’s process for shrinking its bond holdings, in line with earlier statements from Fed Chair Janet Yellen that the process would run quietly in the background. Beginning in October, the Fed started allowing up to $10 billion of securities to mature each month. We expect that to rise to $20 billion starting in January.

Looking ahead

The Fed also updated its “Summary of Economic Projections,” which offers insights on the committee’s expectations for the future pace of rate hikes, as well as its expectations for the broad economy.

Markets pay close attention to the Fed’s “dots plot,” as it gives them a glimpse at the interest rate expectations of various committee members. At the December meeting, the median federal funds rate projection for the end of 2018 was 2.125%, or a range of 2% to 2.25%, indicating an additional three rate hikes next year. That is consistent with the median projection from September’s meeting. The median projection for year-end 2019 was also unchanged at 2.88%. Taking this all in, the median projections point to three rate hikes in 2018 and two more in 2019.

The only projection that did move higher was the projection for 2020, which inched up to 3.06% from 2.88% in September.

The median projection for the “longer run” held steady at 2.75%. We think the “longer run” projection has implications for the trajectory of long-term Treasury yields, since they can be thought of as the average expected federal funds rate over the next 10 years, plus a term premium. Although we think long-term yields will move modestly higher next year, a low terminal rate will likely limit the upside.

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There were plenty of updates to the economic projections, as well. The median projection for the change in GDP for 2018 increased to 2.5%, from 2.1% in September. Growth projections for 2019 and 2020 were also modestly higher: 2.1% and 2.0%, respectively, which is generally in line with the average year-over-year change in GDP over the past five years. At the press conference following the meeting, Fed Chair Yellen said that some tax stimulus had been incorporated into the growth forecasts.

Consistent with the Fed’s assessment that the labor market continues to strengthen, the median projection for the unemployment rate dropped to 3.9% for both 2018 and 2019. The “longer run” median projection remained at 4.6%.

The median projections for core personal consumption expenditures—the Fed’s preferred measure of inflation—were completely unchanged from September’s meeting at 1.9% for 2018 and 2.0% for both 2019 and 2020.

Market reaction

Treasury yields fell after the FOMC statement and updated economic projections were released, likely due to the fact that the median projection for next year’s federal funds rate range was unchanged at 2.125%.

It was initially thought that any updated growth projections would also come with increased projections for more rate hikes. The market appeared a bit disappointed that the 2018 projection of three hikes was left unchanged.

Keep in mind that Treasury yields had already risen significantly over the weeks leading up to the meeting in anticipation of the hike. Two- and five-year Treasury yields had risen by more than a half of a percentage point since early September, so even with the post-meeting decline, short- and intermediate-term Treasury yields remain at their highest levels in years.

What investors can do now

Although we do expect the Fed to continue gradually boosting its benchmark interest rate range next year, we don’t think fixed income investors should rush to the exits. The Fed’s influence is greatest on rates at the short end of the yield curve—the effect of interest rate changes on long-term yields isn’t as big.

That’s why bond yields don’t all rise in lockstep following a Fed rate hike. Longer-term bond yields are affected most strongly by expectations for growth and inflation, along with global supply/demand dynamics. Over time, rising inflation expectations tend to push long-term prices down and yields higher—until rate hikes begin to slow economic growth and reduce inflation expectations.

And even in a rising-rate environment, fixed income investments can still provide positive total returns, due to the predictability of the income stream. The Bloomberg Barclays U.S. Aggregate Bond Index posted total returns of 3.3% for the year through Dec. 12, despite the Fed hiking rates two times (as well as the market anticipating today’s hike) and beginning its balance sheet reduction process.

Holding high-quality bonds offers other important benefits, as well, such as diversification from stocks and generally lower volatility. Over the long run, bond holdings can allow you to take risk in other parts of your portfolio, by potentially holding up when stock prices fall. Higher rates can also lead to opportunities for investors looking for higher yields.

We suggest keeping the average duration of your fixed income portfolio in the short- to intermediate-term range—for instance, three-to-seven years. And for those investors still sitting on the sidelines waiting for rates to move even higher, keep in mind that in past cycles, bond yields have tended to peak (and prices reach their lowest point) before the Fed was finished hiking rates—just another reminder that it’s difficult to time the market.

What you can do next

  • Make sure your portfolio is diversified and aligned with your risk tolerance and investment timeframe. Want to talk about your portfolio? Call Adam Ausloos 414-206-2062

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