March 6, 2017— A lot can change in two weeks, especially in the financial markets. It was just two weeks ago that we argued that the Fed was likely to take a pass at their March 14-15 meeting and opt to wait until later in the year to hike rates. Although the economic picture has not changed significantly, the market expectations of a rate hike have changed dramatically, moving to near certainty. We expect the Fed to react opportunistically and raise their benchmark interest rate by 25 basis points next week. And given our expectations for continued, solid economic growth, we expect them to raise interest rates two more times in 2017.
The market prices it in
The market for fed funds futures is the key metric referenced by analysts, the financial press, and even the Fed themselves to gauge overall market expectations of interest rate movements by the Fed. In the latter half of February, those expectations had indeed increased, based on improving economic data. The market priced in a low of 24% as late as February 8, then moved up to 50% by the end of the month as solid data continued to come in.
The real stimulus appears to have been President Trump’s speech to a joint session of congress on February 28. In the speech he laid out an ambitious policy agenda that we believe would be supportive to short-term economic growth and correspondingly to markets. (More detail on anticipated impacts is available in our Capital Markets Forecast). Trump did not offer significantly more detail about his policies than were already available, but he was widely reviewed as appearing presidential and serious, an encouraging sign for markets that have also witnessed a sometimes erratic and unconventional governing style.
The expectations for a Fed rate hike skyrocketed the following day and have continued to move up since. Indeed, Federal Reserve Chair Janet Yellen delivered public remarks on Friday, March 3 and indicated that a rate hike is likely, provided there are no intervening economic data that surprises to the downside.
It’s not all about Trump
Although the chart above and the timing of expectations would seem to imply that the Federal Reserve’s policy was wholly contingent on political developments, it is important to understand that isn’t the case. The short-term expectations of when the Fed will hike have certainly been affected by the new administration’s demeanor, but the overall, longer-term argument for the Fed to normalize policy with gradually higher interest rates is supported by economic developments. As we discussed two weeks ago, economic data on the labor market, growth, and inflation alone support a rate hike even if the Fed has felt restrained by fiscal uncertainty in D.C.
Looking at the actual facts, the economic case for rate hikes was bolstered last week with the release of the Institute for Supply Management’s indexes for both the manufacturing and the service sectors of the economy. Both indices beat market expectations and continue their upward trends. The manufacturing sector was in decline in early 2016, recovered a bit in the middle of last year, and has roared back to life over the past several months. The bigger, services side of the economy did not decline outright in 2016, but certainly decelerated, giving the Fed some angst. Like the manufacturing sector it is now accelerating.
Source: Institute for Supply Management; WTIA
Our core narrative remains unchanged. We believe the domestic economy is strong and we maintain a positive outlook for 2017. What has changed is market expectations for a rate hike next week. We believe the Fed will take advantage of that opportunity and raise the federal funds rate by 25 basis points. With the economy appearing to be on solid footing we believe there will be two more rate hikes in 2017. We think the Trump administration’s policy agenda will add to short-term growth this year, but we recognize the risks as well. We are keeping a close eye on the political economy and its real potential to take the market narrative in a different direction. For the time being, all of this continues to support our mild overweight to risk assets and underweight to core fixed income.
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