Fed kicks off spring with rate hike

A perspective from E*TRADE Capital Management, LLC

03/21/18

The long and deliberate march higher continues. The Federal Open Market Committee (FOMC) increased the federal funds rate by 0.25% to 1.50–1.75%, or 150–175 basis points (1 bp = one one-hundredth of a percent) at its March meeting. Based on previous Fed signals, this sets up to be the first of three rate hikes in 2018.

The move marked Jerome Powell’s debut in the interest rate game as Fed chair. Powell seemed to go out of his way to make this a no-surprise event. In semiannual testimony to Congress last month, he reiterated the Fed’s intentions to baby-step its way toward normalized monetary policy.1

“My personal outlook for the economy has strengthened since December,” Powell said.2 Perhaps the market, still in the getting-to-know you phase with Powell, wasn’t used to personal comments from the Fed chair. Or maybe it was still jittery from the February correction that sparked from inflation fears. Whatever the reason, the market appeared to take Powell’s comments in aggregate as hawkish, potentially signaling a more aggressive rate approach. And maybe even a fourth hike this year.

Those concerns seemed to subside after a string of softer-than-expected data, including wage growth and business and consumer price data. But it could indicate the market may be growing more sensitive to signs of the end of this “Goldilocks” scenario, where the economy continues to accelerate while the Fed hikes rates.

What could this mean for the market?

The market had (very) little doubt about this increase. The CME FedWatch Tool, which calculates unconditional probabilities of FOMC meeting outcomes, pegged the chances of a 0.25% hike at approximately 94%.3 What equities, foreign exchange, and bonds will likely key in on, and possibly react to, is the Fed’s outlook beyond this increase.

Eyes are likely to be trained on the yield curve, or the differential between short- and long-term Treasury yields. One common measure of the yield curve, the spread between 2- and 10-year yields, has been flattening again recently, perhaps due to short-term rates rising in anticipation of this hike.

In February, the bond market had fixated on the 10-year Treasury yield’s upward climb and the possibility of it hitting 3%. While low historically, the market views 3% as an important psychological level—the 10-year is a benchmark that helps set the price for many (if not all) assets. The more attractive the yields are on safer assets, like government bonds, the less attractive investors may find equities.

US benchmark Treasury bond yields, 3/21/2018

Source: The US Department of the Treasury


Is another rate increase on the horizon?

The most likely scenario for the second hike of the year is at the June 12–13 meeting, which will be accompanied by a press conference.

Though on an upward trend, the fed funds rate remains quite low from a historical perspective. Adjusted for inflation, it remains negative, i.e., below the rate of inflation. An accelerating economy, the Trump administration’s tax cuts, and higher government spending add complexities to the inflation story, and thus the Fed’s track.

The fed funds rate since 2008, 3/21/2018

Source: The US Department of the Treasury


The bottom line for investors

This interest rate environment remains extraordinary, one that still questions what is “normal” for this particular rate hike cycle. And just because the Fed intends to move rates up further doesn’t mean rates will rise across the maturity spectrum. Growth, inflation, and the federal deficit are poised to have a significant say as well.

So, straightforward Fed policy amid an environment fraught with uncertainties, both economic and geopolitical, makes for an interesting dichotomy. What does that mean for investors?

In our view, it’s the well-diversified portfolio that has a healthy mix of domestic and global equities, fixed income securities across the credit and maturity spectrum, and cash that can handle all types of market scenarios over the long term. Add in last month’s correction and now may be as good a time as any in recent memory to find value. For example:

  • A stronger dollar could benefit domestic small caps, which typically occurs amid steady rate hikes. However, should the dollar continue to weaken, it may make certain international equities more attractive.
  • A brighter global growth story could make direct exposure to foreign markets attractive for certain investors, particularly by way of commingled vehicles such as mutual funds or exchange-traded funds (ETFs). Multinationals could provide indirect opportunities in this increasingly globalized economy as well.
  • Short-term bonds, which are on their way to delivering not-to-be-ignored yields, can add meaningful portfolio ballast.

For investors, Fed decisions can serve as checkpoints and impetus to determine whether a portfolio is best positioned to meet their long-term 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 visit us at etrade.com to chat with us online, send us an email, or call us if you like at 800-ETRADE-1 (800-387-2331). We’re always ready to help.

You can also learn more about E*TRADE Personalized Investments here.


1. Monetary Policy Report, February 23, 2018, Board of Governors of the Federal Reserve System. https://www.federalreserve.gov/monetarypolicy/files/20180223_mprfullreport.pdf

2. Smialek, Jeanna. “Here’s What We Learned From Powell’s First Fed Chair Testimony,” Bloomberg, 27 Feb. 2018. https://www.bloomberg.com/news/articles/2018-02-27/here-s-what-we-learned-from-powell-s-first-fed-chair-testimony

3. As of March 20, 2018, according to http://www.cmegroup.com/trading/interest-rates/countdown-to-fomc.html