Markets, We Have Liftoff

December 18, 2015

comet and stars in the skyHalley’s Comet appears about every 75 years to light up the night sky. While it may seem that long since the last Federal Reserve (the “Fed”) rate hike, it was actually only 9 years before yesterday’s long awaited liftoff. The Fed unanimously voted to increase short term rates by 25 basis points to a corridor rate of 25-50 basis points. We would like to take the opportunity to address several of the questions you may have about the Fed rate hike.

Was this Hawkish or Dovish?1

Actually it was a bit of both. In the statement and Janet Yellen’s press conference the Fed was careful to reassert a “gradual” tightening of monetary policy accompanied by continuing to reinvest bond proceeds the Fed holds. They also included new language focusing on international developments and commodities in an effort to gain flexibility should volatility or the strong dollar facilitate a slower rate hiking cycle. These were dovish signs.

On the hawkish side, the Fed left their dot plot steady for 2016 indicating four rate hikes for both 2016 and 2017. Currently the futures market is only pricing in two rate hikes in 2016 and some thought the Fed would reduce their rate hike estimates, conducted quarterly, for 2016. In addition, while increasing the Fed funds rate 25 basis points, the Fed increased their deposit rate by 50 basis points. The latter is the rate the Fed pays to member banks for required and excess reserves held at the Fed. The larger increase would be considered hawkish since banks are now incentivized to hold more funds at the Fed earning .50% risk free rather than lend them out. This decreases the velocity of money, and is in contrast to most other central banks who currently have negative deposit rates (i.e. they charge member banks to keep reserves instead of lending them out).

How is the U.S. Data?

The glass is more than half full, but the data does remain mixed. On the employment side, the U.S. has experienced very strong gains and many economists believe the Fed estimate of a 4.8% unemployment rate for the end of 2016 is too high. With increases to employment we should start to see more wage inflation enter the economy. The consumer is also in great shape and will increasingly contribute to GDP in 2016 with tailwinds from stronger sentiment, and lower fuel prices.

Manufacturing remains very weak due to a global slowdown and stronger dollar and this will continue into 2016. Remember though, the U.S. is not a manufacturing economy, we are a consumption and services economy. In fact, manufacturing only contributes around 12% of GDP compared to 70% for consumption2.

I’m looking to buy a home. Does this mean 30 year mortgage rates will increase by .25%?

No. Mortgage rates follow yields on mortgage-backed securities (MBS). These bonds track 10 year treasuries and not short-term rates. Also, the Fed owns a lot of MBS and keeps reinvesting the proceeds from these securities back into other mortgage securities which should keep loan rates down. While longer-term rates should remain steady, short-term and revolving credit lines will increase.

Will Savings Rates Increase?

Unfortunately savings rates probably won’t increase much if any until the Fed increases rates again. Banks such as Bank of America and Wells Fargo were quick to increase their prime lending rate, but most banks will be hesitant to increase savings rates.

Who Votes on Fed Policy?

Good question. The Federal Open Markets Committee (FOMC) is made up of nineteen members, twelve of which vote on policy. These include the seven members of the Board of Governors, including Janet Yellen nominated by President Obama, and the twelve Presidents of the Reserve Banks located in Boston, New York, Philadelphia, Cleveland, Richmond, Atlanta, Dallas, St. Louis, Chicago, Minneapolis, Kansas City, and San Francisco. Of those twelve, the Bank of New York is granted a permanent vote and the role of Vice-Chair, the other four votes rotate on one-year terms. This means that the voting committee can tilt a bit towards the hawkish or dovish side depending on the year.

So What is the Take Away?

In our view the rate hike is a positive move as it removes the largest unknown in the global markets and associated volatility. We still believe that fixed-income securities will remain under pressure in 2016 and would tilt towards equities. However, we do not believe that high-yield bonds are in imminent danger of a total collapse and were pleased to hear Chair Yellen comment affirmatively that the committee is watching liquidity in those markets. 2016 becomes a year of divergence between the Fed and other central banks around the world. Volatility relating to oil prices, FX rates, and GDP growth will persist and we believe active management is preferred.

1 - Hawkish is less accommodative fiscal policy, and associated with tightening credit and rising rates. Dovish is more accommodative fiscal policy to facilitate credit expansion and associated with decreasing rates.
2 -

Any views or opinions expressed are those of Washington Trust Wealth Management. The information provided does not constitute legal, tax, or investment advice and it should not be relied on as such. It does not take into account any investor’s particular investment objectives, strategies, tax status, or investment horizon. Please consult with a financial counselor, attorney, or tax professional regarding your specific investment, legal, or tax situation. It should not be considered a solicitation to buy or an offer to provide investment advisory or other services. The information may change at any time without prior notice and is based on data obtained from reliable sources; however we cannot guarantee that the information is accurate or complete.

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