How today’s Fed rate hike affects investors
Dr. Brian Jacobsen, CFA
To paraphrase Churchill: Now this is not the end of low rates. It is not even the beginning of the end. But it could be the end of the beginning of the low-rate era. The path to higher rates will likely be long.
The Federal Reserve’s (Fed’s) policy move is exactly what the market expected. The target range for the federal funds rate is now 25 basis points (bps; 100 bps equals 1.00%) to 50 bps. Interest on reserves will be set at the upper end, and the overnight reverse repo rate will be at the lower end. This could make the actual federal funds rate average something close to 33 to 35 bps instead of moving up a full 25 bps to 37.5 bps. That’s probably trivial, though, as you and I don’t borrow at that rate. Market rates already moved up in anticipation of what the Fed would do.
Future rate hikes will depend on actual and expected progress toward the Fed’s inflation objective of 2%. While this could be interpreted as the Fed providing no guidance on what the future policy path looks like, the Fed downshifted its hiking path in the Summary of Economic Projections, and it stressed in its policy statement that rates would stay below normal “for some time.” The Summary of Economic Projections shows a median projection of four hikes in 2016, but the Board of Governors is dovish and may trim those hikes to only two in 2016.
Let’s face it: The Federal Open Market Committee (FOMC) has been really good about telegraphing what it would do. This means the only thing that should be surprising going forward is if the Fed reveals any surprises. If the Fed sprung a rate hike on us with no warning, then I could see why the markets would sell off and the dollar would skyrocket. But that’s not what the Fed has done or will likely do.
The Fed may have responded a little late to the financial crisis. It may have cut rates too slowly initially. It may have then been a bit too erratic in the financial crisis. But that’s all behind us. Since 2013, the Fed has been much more systematic and predictable.
Is now the right time to hike rates?
It's not a question of whether now is the right time to hike; it's a question of whether the Fed is hiking the right way. The Fed had, and has, a significant focus on the federal funds rate. Other rates matter, and those have already been adjusted. But quantities matter, too. The Fed paid interest on bank reserves out of a fear that reserves created from the Fed’s asset-purchase programs would have unintended consequences, such as causing rapid inflation. Now, the normalization process is going to slowly unleash those reserves or let them diminish when the Fed lets its own balance sheet shrink. That process should start toward the end of 2016 or the beginning of 2017.
You can think of this as a controlled burn of all the kindling the Fed put into the financial system during the financial crisis. Only after those reserve balances are back to more reasonable levels will we likely be at a point where monetary policy can operate more normally. That’s probably at least two years away.
A few thoughts on the Fed’s approach
- A data-dependent Fed that is regularly signaling what it plans to do in the near term is positive for those who like to plan. While the Fed can’t predict what the data will say, it can at least lower uncertainty around the path of policy moves by issuing a warning about what it plans to do one or two meetings ahead of doing it.
- The Fed is neither moving too aggressively nor erratically. The Fed’s measured approach can help tame the pace of interest-rate rises that are relevant to you and me, such as the rates on mortgages, auto loans, and the yields on our investments.
- This approach can also help promote stability in the fixed-income markets, among currencies, and in commodities markets. The Fed’s cautious, data-driven approach can also help push equities higher by keeping financial conditions loose and fanning the flames of economic growth.
Some predictions
I anticipate that we will see merger and acquisition activity in 2016 surpass the record levels of 2015. Many of these deals could be in the energy and materials sectors, in which companies salvage balance sheets and deal with higher debt burdens in the face of low commodity prices, as affected by interest-rate policy. I also think we could see a pickup in residential real estate and bank lending activity. Those who were on the fence about borrowing will want to get it done now that the Fed has rung the bell on future rate increases.
What’s next for the Fed and investors?
After the rate hike, how will the Fed normalize monetary policy?
- Target a range of 25 bps to 50 bps for the federal funds rate
- Pull market rates up by increasing the interest on reserves to 50 bps
- Push market rates up by increasing the overnight reverse repurchase rate to 25 bps
- Keep reinvesting proceeds of its portfolio of securities until well after the first hike and then stop reinvesting and let those securities just die off naturally
In case of emergency, the Fed could:
- Cut rates back to zero
- Go negative with the interest on reserves (punish banks for not lending out their reserves)
- Do more asset purchases
How Fed rate hikes might look in the future:
- Going forward, the Fed’s data-dependent hikes could look a lot like its data-dependent tapering of quantitative easing, which was pretty consistent and didn’t look very data-dependent.
- Two more hikes to a 0.75% to 1.00% window by the end of 2016 is likely. The Fed will likely stop reinvesting proceeds of its portfolio in late 2016. The Fed’s balance sheet will then start to naturally shrink as assets mature.
What should investors keep in mind for their portfolios?
- Emphasizing a data-dependent but shallow path means there is uncertainty around the path of rates, but the Fed will try to signal well in advance what future hikes might look like. This should be stabilizing to financial markets.
- Most of the damage (a stronger dollar, lower commodity prices, and an emerging markets sell-off) of a hike is probably already done.
- The FOMC of 2016 is more hawkish than the FOMC of 2015, but the path to normal is going to be very slow. This should be good for the markets.
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The views expressed are as of 12-16-15 and are those of Dr. Brian Jacobsen, CFA, and Wells Fargo Funds Management, LLC. The information and statistics in this report have been obtained from sources we believe to be reliable but are not guaranteed by us to be accurate or complete. Any and all earnings, projections, and estimates assume certain conditions and industry developments, which are subject to change. The opinions stated are those of the authors and are not intended to be used as investment advice. The views and any forward-looking statements are subject to change at any time in response to changing circumstances in the market and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally, or any mutual fund. Wells Fargo Funds Management, LLC, disclaims any obligation to publicly update or revise any views expressed or forward-looking statements.
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