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  • Market Insights

    Markets Still Don’t Believe the Fed

    Eric Fine ,Portfolio Manager
    December 15, 2016

    Contributors: Eric Fine, Portfolio Manager for Emerging Markets Fixed Income; Natalia Gurushina, Economist for Emerging Markets Fixed Income; Charles Cameron, Deputy Portfolio Manager for Natural Resources Equity; and Fran Rodilosso, CFA, Head of Fixed Income ETF Portfolio Management.  

    Fed Raises Interest Rates for the First Time in 2016

    The Federal Reserve (the “Fed”) confirmed its optimism for the U.S. economy yesterday by signaling a faster pace of tightening in 2017, as well as by delivering a widely-expected 25 basis point rate hike. This was the Fed’s first hike since December 2015 and only its second since the financial crisis of 2008. It was the projection of a slightly accelerated pace of tightening and some comments by Fed Chair Yellen in the press conference that caught markets off guard, and both equity and fixed income prices moved lower yesterday.

    We expected higher yields and a stronger U.S. dollar prior to this development, and the Fed’s actions strengthen the case. This is likely to be negative for emerging markets hard- and local-currency bonds. Higher relative interest rates and growth rates in the U.S. are a powerful attractor to the U.S. dollar. Moreover, emerging markets funds could experience outflows for emerging markets-specific reasons, in addition to the likelihood of outflows from bond funds in general. Even if credit quality remains stable, the simple math of higher U.S. Treasury yields means losses on bond prices. It is worth noting that U.S. yields have been declining for 35 years and that until very recently there was broad and deep conviction in the market that interest rates would be low “forever.” In other words, the context of the Fed’s moves could point to an important turning point.

    Key Takeaways on Fed Hike

    Here are the key takeaways from the Fed’s hike, which resulted in a 0.25% increase in short-term interest rates to a range of 0.50% to 0.75%:

    • Inflation: Higher inflation and inflation expectations do matter for the Fed. As a side note, U.S. headline CPI (consumer price index) edged up to 1.7% year-on-year in November, while the Fed’s preferred measure of inflation expectations is now near 2%. In the short term, higher energy prices may boost inflation going into 1Q of 2017 (the base effect). In the longer run, delivering fiscal stimulus in the later stage of this cycle with tighter labor markets can prove very inflationary. Both may embolden the Fed’s hawkish faction.

    • Yield Curve: The U.S. Treasury curve bear-flattened (short-term rates moved more than long-term rates, though the whole yield curve shifted upward) after yesterday’s Fed decision. If this trend continues, the market is likely indicating that the U.S. economy cannot handle Fed rate hikes, and that the pace of hikes should be slowed.

    • Upward Risks to Growth: U.S. election results have created the possibility of a fiscal expansion that could boost growth expectations. Tax cuts and structural reform could boost confidence. The Fed does not expect U.S. GDP growth to rise above 2.1% in its forecasts, so any growth upside may push the Fed in a hawkish direction.

    • Markets Still Dovish: Markets are still assuming the Fed will be less aggressive than the Fed itself has indicated. Although markets have nearly caught up to the Fed’s 2017 plans, they appear to be pricing in significantly less tightening than what the Fed is signaling over the course of 2018 and 2019 (see chart below). Should the market catch up to the Fed, let alone begin to fear that the Fed has fallen behind the curve, there is potential risk of further duration selloffs and U.S. dollar appreciation (a higher likelihood if the new Trump administration delivers its promised fiscal stimulus).


    The timing of the next Fed rate hike will depend on many factors. The Fed gave little indication that Trump’s election had altered its economic outlook, and Yellen has expressed a wait-and-see approach to the “cloud of uncertainty” surrounding Trump’s plans. But a projection of three hikes in 2017 would certainly put a 1Q 2017 hike on the table.

    Source: Bloomberg LP. As of 12/14/2016.