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Fed Approves First Rate Hike of 2017

Buoyed by employment growth and solid consumer spending trends – as well as improving corporate earnings – the Federal Reserve Board (Fed) agreed to raise rates Wednesday, hiking the federal funds target rate by 25 basis points to a new range of 0.75% to 1.00%.

Federal ReserveThis was the first rate hike of 2017, following a 0.25% increase on Dec. 14, 2016. Prior to that, the last rate hike had come in December 2015.

Wall Street had been anticipating the new rate hike based on earlier comments from Federal Reserve Board Chair Janet Yellen.

On Feb.14, she told the U.S. Senate Banking Committee that "the committee will evaluate whether employment and inflation are continuing to evolve in line with these expectations, in which case a further adjustment of the federal funds rate would likely be appropriate."

In announcing the new rate hike Wednesday, Yellen reiterated that if economic factors such as employment and business investment continue to strengthen, she expects the Fed to continue to gradually increase rates over the next two to three years.

U.S. employers have added more than 200,000 new jobs each of the past two months, and retail sales were up 5.6% year-over-year in January, according to the Feb. 15 retail sales report from the U.S. Department of Commerce.

Corporate earnings have also improved in recent months. The consensus view for inflation is 2.4% for 2017 and 2.3% for 2018, which is considered to be reasonable.

Gross domestic product (GDP) growth – another measure the Fed considers in determining whether to raise rates – has also strengthened recently. The consensus projection for real GDP growth is 2.3% for 2017 and 2.4% for 2018, according to the March 10 Blue Chip Economic Indicators. We have recently increased our estimate of growth to 2.7% for 2017, which is slightly higher than the consensus view.

As the graph below illustrates, the Fed cut rates from 5.25% to 0.00% in a 16-month period during the Great Recession, with the final cut from 1.00% to 0.00% coming in December 2008. The rate stayed at (or near) 0.00% for seven years until the first rate hike in December 2015.

Federal Funds Target RateWhile the Fed was expected to approve several more rate hikes in 2016, weak economic factors convinced the board to hold off on any further rate hikes until December 2016, when it raised the rate 25 basis points to a range of 0.50% to 0.75%.

If the economy remains strong, we expect the Fed to make more rate hikes in 2017. While we expect the pace of rate hikes to increase, we don't expect a repeat of the 2004-06 period when the Federal Reserve, under Alan Greenspan, raised rates 17 times.

Yellen concurred with that assessment in her press conference Wednesday. Referring to the rapid rate of hikes during 2004-06, Yellen said: "We're not envisioning something like that. We think gradual increases in the Fed funds rate will be appropriate."

Because of the steady and predictable pace of hikes during that period, many types of bonds actually managed to have positive returns despite the rise in rates. If rate hikes are handled in a similar but slower-paced fashion this time, that should soften the blow of higher interest rates for bondholders.

However, there is one fundamental difference between now and the 2004-06 period.

Absolute yield levels were much higher then than the exceptionally low yields we have today. As a result, investors should be less opportunistic about the possibility of earning positive returns. At best, very low single-digit returns should be expected.

The biggest mitigating factor against sharp losses in bonds is that foreign yields are exceptionally low – still negative in many countries – which should make the U.S. Treasury market look relatively attractive to foreign investors, particularly if the rate hikes lead to a stronger dollar. 

While a strengthening dollar could be good for U.S. bondholders, it may be detrimental to U.S. companies that do business abroad. A stronger dollar makes imports cheaper, but makes American goods and services less competitive abroad. 

For net savers, however, we believe a series of small rate hikes may be beneficial without adversely affecting the economy or consumer spending.

Bank savings accounts and money markets have been paying in the range of 0.00% to 0.01%, so traditional savers have been getting essentially nothing for their dollars.

As the Fed rate rises, consumers should benefit from better savings returns.

The next Fed meeting is scheduled for May 2 – 3.

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