Thursday 15 December 2016 by Craig Swanger Opinion

US Federal Reserve increases rates for the first and only time in 2016

In a move anticipated by the whole market, the US Federal Reserve (Fed) has increased its target rate by 25bps. This has been the only increase for the year, despite announcing this time last year that they anticipated four rate increases in 2016

fed

The US Fed has announced a much anticipated 25bps increase in rates. Markets were expecting the increase so reactions were minimal – but there was some movement in response to the Fed announcing three potential increases in 2017, up to four in 2018 and another three in 2019. Notably, 10 year bond rates jumped to above 2.5%pa for the first time since 2014 on the news.

December 2015 saw the first increase of rates by the Fed since the GFC. Like history repeating itself, the move was widely anticipated by markets, and the commentary on expectations for 2016 rate increases similarly created market interest.  The 10 year yield jumped 17bps on the announcement that the Fed members thought rates would be increased four times in 2016.  Within a month, the market had all but eliminated those expectations and the 10 year yield had dropped back to 1.9%pa.

During 2016, the US economy continued to strengthen.  It remains, as we often say, “good but not great”.  The Fed, typically too optimistic, expects an average 2.0%pa GDP growth in the years ahead, which is below historic averages.  However, the world has changed – baby boomers are retiring and therefore spending less; there are less people in the workforce, so 2.0%pa growth is enough to continue to improve employment.  Unlike Australia, the US has increased total employment in 2016, which is the primary objective of a central bank like the Fed.

So, the extent of their increases in 2017 will come down to three factors:

1.   Can the US economy's underlying strength continue?

We see no reason to expect otherwise, as consumer spending and confidence remains high, business investment is moderate and strengthening, housing construction is rising and exports have stabilised.

2.   What impact will Trump have on the economy in 2017?

Talk of tax reductions, opening up of new oil exploration sites and a higher oil price, and the early stages of any infrastructure projects will be positive for the economy.  The wild card is Trump shifting priority to some of his more radical policies – such as implementing severe import tariffs – which will most likely be negative for US incomes and risk excessive inflation.  However, Trump is far more likely to prioritise the easier and more popular wins in infrastructure and tax policy. Overall, if Trump impacts the economy in 2017, it will likely be positive.

3.   How much of an increase in rates will be too much for the "good but not great" US economy to bear?

This is the greatest unknown, and in our view where markets have lost sight of fundamentals:

  • Higher US interest rates hurt mortgage holders, that is the vast majority of consumers
  • More immediately, they also push the USD up against other weaker currencies. A higher USD makes US exports less competitive, which hurts the economy, particularly when most of the rest of the world are still battling stagnation
  • Finally, higher rates make US government debt harder to service, reducing the enthusiasm of conservative Republicans to support Trump’s big spending plans.  

We believe that markets – in terms of equity markets’ expectations of increased earnings and bond markets’ expectations of increased inflation – have priced in the full impact of Trump’s proposals, without considering the knock on impacts above. 

In the context of an embattled European economy, weakness in Japan, and the prospect of higher interest rates for the highly leveraged Chinese economy, there is all the likelihood of the USD increasing strongly in 2017. This could once again cause the Fed to increase rates slower than they expected to at the start of the year.

For Australian investors, USD holdings continue to make sense both in terms of the quality of the credits and the hedge against a weaker global and Australian economy – even more so in the context of the Trump era ahead. 

Get your free copy of The Benefits of Corporate Bonds eBook

Get a copy of The Benefits of Corporate Bonds eBook

Subscribe to The WIRE newsletter

Sign up to a free weekly newsletter to get the latest investment news.