U.S. Fed stands pat in surprise move

A perspective from E*TRADE Capital Management, LLC

12/14/16

Contrary to expectations, the U.S. Federal Reserve decided to leave its benchmark interest rate unchanged in December. Here’s our take on what it means.

After its scheduled meeting on Wednesday, December 14, 2016, the Federal Open Market Committee announced that it will leave its benchmark interest rate, known as the federal funds rate, unchanged in a range of 0.25–0.50%, or 25–50 basis points. A basis point is one one-hundredth of a percent.


While acknowledging some encouraging economic news and a pickup in inflation, the committee believed that the U.S. economy is not yet strong enough to justify a rate increase. In addition, as this decision comes just a few weeks after the election of Donald J. Trump to the U.S. presidency, market observers believe it’s possible that the Fed wishes to take a wait-and-see approach as the new administration takes shape.

The Fed built its rationale on generally mixed U.S. economic data. Employment has risen, though at a generally slower rate when compared to 2015. Plus, in spite of the 3.2% growth posted in the third quarter, the economy has been expanding only modestly.

What it means for markets

The financial markets had expected a rate increase. As a result, many predict that volatility may jump as investors process this surprising news.

  • U.S. equities out of gas? Low interest rates have been a friend to U.S. stocks since rates bottomed out after the financial crisis of 2008. Some analysts believe that the benefits of ultra-low rates have now been fully realized, and any further appreciation for U.S. stocks would need to come from earnings growth or price/earnings multiple expansion (i.e., where investors are willing to pay a higher price for the same level of earnings). Despite these obstacles, the bull market is now in its 8th year, and secular bull markets can often last for more than a decade. In addition, some believe President-elect Trump’s fiscal policies and desire to reduce regulation may help sentiment and ultimately push equities higher, at least in the short term.

  • Short-term bonds could rally. Because shorter-term bonds are typically the most sensitive to changes in fed funds policy, they could be the biggest beneficiaries. But that doesn’t mean that other fixed income sectors won’t also benefit: Fixed income analysts believe investment-grade and high-yield corporate bonds may rally on continued low debt costs for issuers. It’s important to note, however, that if President-elect Trump follows through on his campaign promises of lower taxes and increased spending—supported by heavy borrowing—market observers predict yields may be pressured higher (and prices lower). This is likely due to the perceived growth and inflationary impact of such policies.

  • The outlook for international equities is unclear. If the U.S. dollar weakens on today’s news, experts believe it could create a challenging environment for some international companies, especially those that are heavily dependent on U.S. customers. In addition, if restrictive trade policies are pursued by the Trump administration, this could serve as a significant headwind for international equities, which have underperformed U.S. stocks for a number of years. However, by some measures, foreign stocks may have considerably more attractive valuation profiles than their U.S. counterparts. This increases the likelihood that investors will eventually begin searching for value in these markets.

Is a rate increase on the horizon?

The Fed projected as many as four rate increases—of 25 basis points each—in 2016. None have occurred. The outlook for future rate increases is uncertain. The Fed is obviously reluctant to increase rates for fear of affecting the markets or upsetting what it sees as a still-fragile economy. We may get more clarity as the policies of the Trump administration take shape, along with additional market action and economic releases as we move into 2017.

The bottom line for investors

The Fed’s decision this month was unexpected, and as a result many believe market volatility is on the near-term horizon. But that doesn’t change our overarching philosophy. We continue to believe that investors with well-diversified portfolios of domestic and global stocks, fixed income securities across the credit and maturity spectrum, and cash should be well-positioned for the future. If stocks rise sharply in the coming days, investors should be mindful that a pullback can still occur. To that, we say: Plan for the unexpected by diversifying—and stay focused on the long term.

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.