Fed lifts benchmark interest rate

A perspective from E*TRADE Capital Management, LLC


At its policy meeting on Wednesday, June 14, the Federal Open Market Committee (FOMC) increased the benchmark interest rate, known as the federal funds rate, by 0.25%, or 25 basis points. The rate is now 1.00–1.25%, or 100–125 basis points (a basis point is one one-hundredth of a percent).

The Federal Reserve (the Fed) noted that despite mixed economic data recently, it had sufficient reasons for the increase. This is in line with the committee’s view, expressed in its May meeting minutes, that the soft first quarter was likely “transitory”1 and that gradual adjustments to monetary policy could help increase economic activity.

The move, which follows 0.25% increases in December 2016 and March 2017, suggests that the Fed remains on track toward normalizing monetary policy and following through with the three hikes some Fed officials predicted for 2017. Also part of that process will be a gradual drawdown of the $4.5 trillion of debt on its balance sheet by scaling back reinvestments in Treasuries and mortgage-backed securities. Officials indicated that process could begin before year-end.

What could this mean for the market?

Fed signals leading up to the decision had most market participants expecting this increase, which represents another marker on its long road toward rate normalization. Notable about the move is that it comes amid muted wage growth and continued low inflation. Market observers also point to moderate economic growth and uncertainty about pro-growth policy like tax reform as an atypical recipe for a rate increase.

That said, some argue that the extraordinary nature of the Fed’s quantitative easing may be prompting the committee to rebuild its toolkit and give itself some flexibility for whatever may come down the road, after years of holding rates extremely low.

As to what happens next, here’s what we’ll be watching:

  • A possible bump in U.S. equities. Domestic equities have surged in 2017, with several major indexes closing at record highs recently. Some argue this increase of the fed funds rate could help provide continued confidence in equities, should the hike not already be priced in to the market. The move could bode well for multinationals, while more interest rate-sensitive stocks, such as telecoms and utilities, could take a hit.
S&P 500 closing values since December 2008

Source: Standard & Poor's®

  • A possible bump in foreign equities too. Higher interest rates and a stronger dollar in the U.S. could lead to an increase in exports from foreign countries, helping to drive higher economic growth abroad and more money into international equities. Of note, foreign stocks have largely outpaced their U.S. counterparts thus far in 2017.
  • The yield curve may continue to flatten. Short-term rates are likely to increase along with the fed funds rate, but that may not be the case for longer maturity Treasuries. Recently, the yields on longer-term Treasuries have been falling. And this so-called flattening of the yield curve—a line that plots interest rates for Treasuries against the length of time they have to reach maturity—could indicate diminished expectations for future economic growth.
2y and 10y Treasury yields since December 2015

Source: U.S. Department of the Treasury

Historically, a steep yield curve has indicated confidence in the economy, while a flatter curve has suggested less optimism. A common measure of the yield curve slope, the 2–10 spread, recently closed at a post-election low. The 2-year has been rising due to the Fed’s rate increases, but the 10-year has been falling with the market questioning prospects for economic growth. A flattening curve can be a good thing for certain financial stocks, such as banks and mortgage REITs, which typically benefit from lower short-term funding costs while lending at higher long-term rates.
2-10 year Treasury yield curve spread since December 2015

Source: U.S. Department of the Treasury

Are more rate increases on the horizon?

The Fed appears to be on track to deliver the three interest rate increases predicted for 2017, barring a major development. Factors that could influence its decision include a significant deterioration in key economic data, particularly output growth, labor market expansion, and core inflation. Possible fiscal, tax, and trade policies, not to mention the market’s reaction to today’s news, may be factors as well.

The bottom line for investors

All investors can use market events, like Fed decisions, as opportunities to review and rebalance their portfolios as appropriate, keeping them aligned with their risk tolerance. We believe 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 all types of market developments over 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 visit us at etrade.com to chat with us online, send us an email, or call us if you like at 1-800-ETRADE-1 (1-800-387-2331). We’re always ready to help.

You can also learn more about our managed account solutions here.

1. Minutes of the Federal Open Market Committee, May 2–3, 2017. https://www.federalreserve.gov/monetarypolicy/files/fomcminutes20170503.pdf