- The Federal Open Market Committee (FOMC) moved off the zero bound by raising the fed funds rate by 25 basis points.
- It’s been nearly a decade since the last rate hike and the first move away from the Fed’s zero interest rate policy (ZIRP) since 2008.
- The decision was wrapped in a dovish statement, with a more hawkish element in the “dots plot.”
In a unanimous decision, the FOMC, led by Chairwoman Janet Yellen, moved off the unprecedented zero bound by raising rates for the first time in nearly a decade; while also soothing markets by reinforcing a “gradual” pace of additional rate hikes to come. The target range for the federal funds rate moves from 0-0.25% to 0.25-0.5%.
The initial benign reaction by the stock market, and the lack of change in the bond market and in the forward curve, suggest this was a very well-communicated rate change.
The quote(s) of note: “The committee judges that there has been considerable improvement in labor market conditions this year, and it is reasonably confident that inflation will rise, over the medium term, to its 2 percent objective.” The Fed said it raised rates “given the economic outlook, and recognizing the time it takes for policy actions to affect future economic outcomes.” Most “dovish” from the statement was the word “gradual” being used twice, including: “…warrant only a gradual increase in the fed funds rate for some time…”
Of note related to the Fed’s inflation mandate (one of two mandates, the other being employment): The Committee states that “in light of the current shortfall of inflation from 2 percent the Committee will carefully monitor actual and expected progress toward its inflation goal.” The reference to actual was seen as dovish in that it suggests the Fed will look for actual, not just anticipated, evidence of wage/price inflation picking up before raising rates again.
Although the vote was unanimous, the newly published update to FOMC rate forecasts show that two officials among the combined group of voters and non-voters saw no rate increase as appropriate in 2015, without identifying them.
The FOMC said it expects to maintain the size of its balance sheet—about $4.4 trillion today—“until normalization of the level of the federal funds rate is well under way.” We believe that the Fed’s approach to its balance sheet—in addition to the pace of subsequent rate hikes—will be the focus of investors’ attention for much of the coming year.
We have been emphasizing that it’s the path of rate hikes from here that is more important than the start date in the cycle. Four times a year, including every December, the FOMC publishes new forecasts, representing an average of its members’ forecasts. The new “dots” on the plot show no change to the FOMC’s 2016 “dot” relative to September; but the 2017 and 2018 dots did move lower. The Fed’s dots did not quite come down as much as the consensus expected, which was one of the only “hawkish” elements to the news today (but good for the financial sector, on which we have an outperform rating). In fact, the FOMC’s 2016 dot implies four hikes next year, which may still be aggressive, especially since the FOMC’s economic projections didn’t change much from September.
There remains a gap between the Fed’s expectations and the market’s, but only in the out years (notably in 2017 and 2018), as you can see in the chart below.
Dots Plot Revised
Fed estimate based on median Federal Open Market Committee (FOMC) projections. Market estimate based on Bloomberg Euro Dollar Synthetic Rate Forecast Analysis (EDSF). Source: Bloomberg, Federal Reserve.
Tortoise and hare
The market’s expectations (the yellow dots) moved up slightly relative to where they were before the announcement today; although as you can see they remain below the Fed’s. Regardless, we believe the Fed will be able move gradually in this cycle. We have been emphasizing the trajectory of this cycle’s rate hikes because it has mattered a lot to equity market performance historically.
There have been 12 rate hike cycles since 1946; five of which were “slow” cycles, and seven of which were “fast” cycles. As you can see in the chart below, when the Fed was historically moving slowly (not raising rates at every, or even most FOMC meetings in a cycle), stocks performed quite well (+10.8%) in the year following the initial rate hike. Conversely, when the Fed was moving more quickly (raising rates at most consecutive FOMC meetings in a cycle), the market suffered a small loss (-2.7%) in the year following the initial hike. In other words, from a market perspective, the tortoise has indeed beaten the hare.
Tortoise Beats Hare
Fast cycle dates: 11/20/67, 1/15/73, 9/26/80, 9/4/87, 2/4/94, 6/30/99, 6/30/04. Slow cycle dates: 4/25/46, 4/15/55, 9/12/58, 7/17/63, 8/31/77. Cycles were set at, or indexed to, 100 to enable growth comparisons. Past performance is no guarantee of future results. Source: Ned Davis Research (NDR), Inc. (Further distribution prohibited without prior permission. Copyright 2015 © Ned Davis Research, Inc. All rights reserved.).
Dollar holds a key
A key determinant of the pace at which the Fed continues to raise rates is likely to center around the U.S. dollar. A stronger dollar acts as a drag on the U.S. economy, and hurts corporate earnings and commodity prices. Continued dollar strength would likely slow the pace of the Fed’s rate increases. Any sustained countertrend moves in the dollar, commodity prices or inflation could trigger a faster pace of rate increases.
There were few fireworks or surprises in the press conference which followed the FOMC announcement; but a couple of exchanges of note. She believes the risk of a recession in the near term remains low given that past expansions have ended due to the Fed waiting too long for inflation to rise and then having to respond quickly. Yellen said she doesn’t see anything in underlying strength which would make her concerned about recession, also noting that “it’s a myth that expansions die of old age.”
Not surprisingly, Yellen was asked about widening credit spreads and the news about the closure of a Third Avenue high yield fund. She noted that credit spreads have been widening since last year, but that Third Avenue’s fund had an “unusual structure;” having concentrated, illiquid positions; and was not representative of most high yield bond funds.
The initiation of rate hikes removes the uncertainty around the start date obviously; but does not remove the uncertainty around the path of rate hikes from here. We believe this will remain a focus by investors in 2016; and is likely to contribute to some of the volatility we believe will persist across the equity and fixed income markets.
(c) Charles Schwab