The Fed throwing caution to the wind? Not so fast.
The U.S. Federal Reserve (the Fed) hiked interest rates again today, raising the target range by a quarter point to 0.75-1.0%. We and, it seems, markets were fully expecting this move, particularly after Fed leaders provided very strong guidance last week that a March hike was in the pipeline. The bigger issue for investors now in our view is the idea that the pendulum at the Fed may be slowly swinging from caution to comfort—which increases the risk of a more orderly pace of rate hikes going forward. Asset prices are digesting this hawkish shift: From the first of March through Tuesday’s market close in New York, U.S. and global equities fell roughly one percent, as measured by the MSCI All-Country World Index, and the 10-year U.S. Treasury yield moved back toward the top of its post-November 2016 election range at 2.6%. Those moves were partially reversed today as the Fed stuck to a gradual tone, reiterating a three-hike pace in 2017 and 2018.
Recent speeches from Fed Chair Janet Yellen, Fed President Bill Dudley and Fed Governor Lael Brainard provided us with a detailed glimpse into the Fed’s outlook for both the U.S. economy and U.S. monetary policy. A few common themes emerged that can help investors understand why the Fed shifted gears today:
- Global growth has improved. – Downside risks to the U.S. from abroad have diminished.
- Inflation expectations have moved up. – Disinflationary risks have decreased.
- Consumer and business confidence is high. – Upside risks to the U.S. outlook have increased.
Put differently, the balance of risks has improved. The Fed appears to have greater confidence that it can continue making gradual progress towards its goals of full employment and price stability.
The path forward
In our view, U.S. fundamentals justify further gradual rate increases. The unemployment rate is at a historically low level and core inflation should continue to edge higher. But several important risks remain, so for the time being we stick to our forecast of two rate hikes in 2017. Our watchpoints as of 15 March 2017 include:
- The risk of an equity market pullback: U.S. valuations are expensive and sentiment is stretched.
- The amplified role of the U.S. dollar in a divergent world: A faster Fed and more dollar strength would add downside risk for U.S. growth and inflation.
- A puzzling slowdown in wage growth in recent months: For the Fed to sustainably hit its 2% inflation target, wages will need to continue trending higher.
- Softness in the hard data. Real GDP growth was underwhelming in Q4 and looks sluggish in Q1.
As such, we are forecasting a slower pace (two hikes) than what the Fed is now projecting (three hikes). Are we making a mistake by fighting the Fed? Not necessarily. It’s important to remember that the Fed has consistently underdelivered the last few years. For example, in late-2014 the Fed forecasted that they would be able to deliver nine or 10 rate hikes by the end of 2016. They only hiked twice.
Investment strategy implications
In late 2016 we held a more aggressive forecast for U.S. federal funds rate hikes than what was priced into the bond market. But the post-Trump election reflation trade and a more aggressive Fed have pushed industry analysts’ consensus forecasts closer to our own. Indeed, the 10-year U.S. Treasury yield is currently trading near our estimate of its fair value (2.6%), leading us to become less negative on the outlook for U.S. government bonds in global multi-asset portfolios.
Meanwhile, U.S. equities have moved well ahead of earnings fundamentals and appear vulnerable to policy risk if federal tax reform is watered down or delayed. We see more compelling opportunities in continental Europe, where economic and earnings fundamentals have accelerated to multi-year highs against a backdrop of significantly cheaper valuations. The Japanese economy has also shown signs of life in recent months but the tight linkages between the Yen and the Japanese equity market remain a key risk factor. Currency trends are consistent with a modest degree of downside risk to the Yen which would likely benefit Japanese shares. Emerging-market-local-currency debt is another area where we see an attractive combination of cheap valuations and improving cyclical fundamentals.