Fed Rate Hike Underscores Improving Outlook

federal-reserve

The bad news is that last week America’s Federal Reserve once again hiked its benchmark interest rate, making financing costs for many individuals and corporations more expensive. The good news is that the rate hike – which came earlier than many had expected a few months ago – largely confirms a broad improvement in economic growth and supports a more optimistic view that markets around the world are at least stabilizing.

In Q1, so far, economic data has generally come in on the stronger side. Since bottoming last summer, consumer confidence soared to its highest level since 2001. Concurrently, the ISM nonmanufacturing index, which measures employment progress and business activity, posted its strongest reading since late 2015. Other indicators, including the small business optimism indicator have also recently touched new high levels.

Since the start of the ‘Great Recession’ in 2008, the Federal Reserve has taken a predominantly “dovish” stance by keeping interest rates artificially low and printing money through a programme known as quantitative easing, or QE for short. The Fed’s consistent mandate since those darker days has been to keep the monetary pedal to the medal until inflation at least hits its two percent target and employment shows meaningful signs of recovery.

Although the Fed’s preferred inflation indicator, the personal consumption expenditure index (PCE), remains below the two percent target at 1.7%, the indicator’s year-over-year increase is up from a low of 1.4% early last year and fast approaching the goal. Meanwhile, U.S. unemployment which peaked at approximately ten percent in late 2009, has fallen below five percent where it has remained for the past year, or so.

Confirming the better employment picture, the U.S. Labor Department reported several days ago employers added jobs at an above-average pace in February due primarily to gains in construction and manufacturing. The 235,000 increase in jobs followed a 238,000 increase in January which was more than previously estimated, making it the best back-to-back rise since last July. Importantly, wages grew 2.8% from the same time a year ago adding to the case for hitting the Fed’s inflation target. The unemployment rate dropped to 4.7%, the lowest level in ten years.

While business confidence and employment data appear to confirm an upswing in activity, overall U.S. economic growth still remains relatively soft by other measures. Gross Domestic Product (GDP) growth, the broadest measure of economic progress, is not suggesting an overheated economy. According to recent reports from the Commerce Department, fourth quarter GDP growth fell to 1.9% from 3.5% in Q3 and market expectations for Q1 2017 are coming in around 2.1%. Although an outlier, the Atlanta Fed recently reduced its real GDP growth estimate for Q1 to just 0.9%. This forecast had been as high as 3.4% earlier this year.

Nevertheless, Fed leaders have been chomping at the bit to raise interest rates. Last month’s relatively strong employment report on top of a 15% surge in the stock market since last November gave them the opening they needed. Some economists worry that plans for government infrastructure spending and a much anticipated tax cut could become bogged down in political wrangling, but the Fed is not waiting around for results this time.

Going forward, expect the Fed to finally meet its stated targets for the year by raising rates a total of three times in 2017. The policymaking team needs to restore lost credibility after balking on their projected rate increase targets in both 2015 and 2016. Janet Yellen has less than one year left on her term as Chair of the Federal Reserve Board of Governors while Vice Chairman, Stanley Fischer’s term will end in June of 2018. Both board members are widely expected to retire while two other vacant positions still need to be filled. Look for the outgoing crew to make their mark and not be seen as falling behind the curve. Barring unexpected geopolitical events spooking the markets, the direction for interest rates in the near term is gradually up.

Longer term, however, global growth and therefore future interest rate increases will likely be capped by the powerful headwinds of a worldwide ageing demographic combined with burdensome government debt levels. At the same time, a plethora of disruptive technologies will keep inflation at bay. In fixed income, we favor a ‘barbelled’ maturity structure for successfully navigating this environment.

Download the PDF version of this article.

The information contained in this article is for information purposes only, and represent the views of the author. It is not intended as specific investment or financial advice, or a recommendation or solicitation to buy or sell any security. Any investments or strategies listed in this article may not be suitable for all investors. Past performance is not indicative of future performance, and as with any investment, prices may fluctuate. It is recommended that advice is sought from a qualified investment professional prior to implementing any financial plan. LOM has made every effort to ensure that the contents herein have been compiled from sources believed reliable, however LOM does not warrant the accuracy, adequacy, timeliness, or completeness of this information expressly disclaims liability for errors or omissions in this information.