U.S. Fed lifts benchmark interest rate

A perspective from E*TRADE Capital Management, LLC

12/14/16

This is the Fed's first move since the election of Donald J. Trump, and is only the second rate increase since 2006. Here's our take on what it means.

After months of anticipation, at its policy meeting on Wednesday, December 14, 2016, the Federal Open Market Committee voted to raise its benchmark interest rate, known as the federal funds rate, by 0.25%, or 25 basis points. This was the first rate increase since December of last year—and only the second in more than 10 years.


Prior to last December, the U.S. Federal Reserve (the Fed) had been in a holding pattern since it lowered rates dramatically in 2008 during the financial crisis. This time, in support of its decision to raise rates, the Fed cited healthy economic growth, an expanding labor market, and a pickup in inflation.

What it means for markets

Through statements over the past months, Fed officials had been conditioning the markets to the possibility of rate hikes in 2016. In fact, the Fed originally targeted four interest rate increases—of 25 basis points each—this year. (A basis point is one one-hundredth of a percent.) However, for various reasons, the Fed held off, and interest rates in the fixed income market declined throughout most of the year.

In the days immediately following the presidential election, though, interest rates quickly jumped higher around the view by many investors that renewed growth and inflation may be likely outcomes of President-elect Donald Trump’s policies. As a result, the Fed funds futures markets had priced in a rate hike at the December 2016 Fed meeting, and a dramatic increase in market volatility on the news is not expected.

  • Good news for U.S. equities? Because higher interest rates reflect an expectation among investors for accelerated growth, they’re generally considered to bolster equity values. That said, many believe higher borrowing costs for corporations may pose a challenge, and more attractive bond yields could create an increasingly compelling alternative to equity investing. Plus, there’s also a degree of uncertainty related to the policies to be pursued by the new presidential administration. That doesn’t mean, however, that history isn’t on the side of U.S. stocks: The bull market that began in early 2009 remains intact, and secular bull markets can often last for more than a decade.

  • Fixed income may be soft. As previously mentioned, even ahead of today’s news, interest rates had already zoomed higher—and many believe they may now even start to price in the next Fed hike, which could come in early 2017. (Since the Fed’s March meeting is the first to coincide with a press conference, many see that meeting as the next most likely opportunity.) Also, if President-elect Trump follows through on his campaign promises of lower taxes and increased spending—supported by heavy borrowing—market observers predict yields are likely to continue their rise driven by the impact such policies could have on growth and inflation. Long-term rates may be most vulnerable, as they’re heavily influenced by investor expectations related to these factors. However, any meaningful move higher may be tempered by surging demand from yield-starved investors, including those in the many countries that currently have rates near, or below, zero.

  • The outlook for international equities is unclear. Relative to U.S. stocks, foreign equities have struggled over the past few years—and market sentiment turned even more negative following the election. Many see a strong possibility that international stocks may trade in a tight range until there’s more clarity on the new administration’s trade policies. This could take some time. Still, international equities do have a level of fundamental support. For instance, weaker global currencies may drive increased exports to the U.S., which may aid improved economic growth abroad. Plus, investors often consider U.S. equity markets to be among the most expensive in the developed world, further increasing the likelihood that they will begin searching for value elsewhere. If, however, the new administration pursues restrictive trade policies, international equities may continue to struggle.

Are more rate increases on the horizon?

From late 2015 through this year, the Fed had projected multiple rate increases for 2017. While a lot has changed in 2016, market observers still expect the Fed’s decisions to be data- and market-dependent. If market volatility is contained, and economic numbers continue to be positive while inflation increases, many believe it is probable that the Fed will move rates higher throughout 2017.

The bottom line for investors

We believe that investors with broadly diversified portfolios of domestic and global equities, fixed income securities across the credit and maturity spectrum, and cash should be well positioned for the future. While the Fed’s decision to increase the federal funds rate is an impactful event that should not be overlooked, it also should not deter investors from staying focused on their long-term investing goals.

At E*TRADE, we’re committed to helping you make sense of the markets. If you have questions or would like to talk about your portfolio, please don’t hesitate to contact your E*TRADE Financial Consultant if you have one, or call us at 1-800-ETRADE-1 (1-800-387-2331). We’re always ready to help.