Hike gave Fed ‘more breathing room,’ says analyst

The U.S. Federal Reserve followed through with its anticipated rate hike, based on “realized and expected labor market conditions and inflation,” the central bank says in a release.

The Fed also pointed to household spending, which “has continued to rise moderately while business fixed investment appears to have firmed somewhat.” On the topic of inflation, the Fed says that has “has increased in recent quarters, moving close to the [Federal Open Market Committee’s] 2% longer-run objective.”

The decision to hike was nearly unanimous, after a nine to one vote. Only Neel Kashkari, head of the Fed’s regional bank in Minneapolis, dissented; Kashkari preferred to leave rates unchanged.

The Fed’s decision was expected, largely due to chair Janet Yellen’s strong hints in a speech earlier this month. At that time, Yellen highlighted encouraging job growth, and positive manufacturing and consumer confidence data. Stock prices were also surging.

Further, ahead of today’s hike, CME Group’s FedWatch Tool indicated there was a 95.2% chance of the Fed raising its target for the fed funds rate to 75-100 basis points, up from 50-75 basis points.

Overall, markets were optimistic in anticipation of the hike. Stan Choe of The Associated Press reported the S&P 500, Dow Jones, Nasdaq composite and Russell 2000 index of small-company stocks had all gained in early trading.

On top of that, “the price of oil climbed Wednesday, the first time that has happened in more than a week. […] That helped lift energy stocks in the S&P 500 index by 1.2%, the biggest gain among the 11 sectors that make up the index,” reported Choe.

After the Fed’s announcement, “markets reacted very favourably,” says Prab Sagoo, associate director at Nasdaq Advisory Services. This was the case even though the announcement came in a little more dovish than expected, he adds. Some were calling for changes to the Fed’s economic outlook and for up to four more hikes in 2017, versus only two more, as has been confirmed.

Still, “we’ve seen a tick-up on the TSX to the range of about 60 points […] and the market is seeing the Fed as offering a much more accommodative policy.” Between 2pm and 3:30pm, the S&P 500 had risen about 12 points.

But Canadian bonds were struggling a bit in the aftermath, says Sagoo. “Bond prices are higher but yields are declining across the board. The shorter end of the Canadian government Treasury curve is down the sharpest because that has the highest correlation to U.S. rates.”

The loonie jumped after the announcement. Due to the dovish nature of the Fed release, says Sagoo, “the Canadian dollar was recovering some its strength,” after dipping over the last few weeks.

How many more hikes, really?

Sagoo says the Fed has been tactical this time around. “It seems they’ve said, ‘Let’s go ahead and raise rates now. It’s pretty much a slam dunk as the economy is good and everybody is comfortable with us raising rates.'”

He adds, “Raising now means [the Fed] gets a little more breathing room and we can hold off on [further hikes] for one or two more meetings, if necessary, and still have room to raise a couple times later in the year. From a tactical standpoint, they’ve done what they needed to do.”

One reason could be the “politically unstable environment,” but the Fed release didn’t comment specifically on the Trump administration. So far, says Sagoo, “there are few indications that Trump’s presidency is going to negatively affect growth in the U.S., given the Fed’s projections are unchanged.”

According to the dot plot, only two more hikes are set for this year, which is unchanged from the Fed’s December forecast. However, the number of Fed officials who think three rate hikes will be appropriate rose from six to nine.

In its statement, the FOMC says the federal funds rate “is likely to remain, for some time, below levels that are expected to prevail in the longer run.”

This is only the third time the central bank has raised rates since the economic crisis.

How fast the Fed hikes really depends on two issues, says Erik Weisman, chief economist and portfolio manager at MFS Investment Management.

“One is how much of this global reflation story, independent of the U.S., is sustainable,” he explains. “Second, will we end up seeing a fiscal package from the Trump administration sooner, and will it meet, or exceed, expectations? If the package is retroactive to the beginning of the year and sizeable, the Fed will find that it’s behind the curve. The macro mix will be really unbalanced in that case.”

Weisman says the Fed could hike more than expected moving forward. “If the rest of the globe shows a bit more inflation and growth, that would wind up being a tailwind for U.S. growth and it would be easier to have a rate of growth that’s higher than the 2% the Fed anticipates,” leading to a more aggressive cycle.

Based on today’s news, he doesn’t plan any portfolio moves. “I still think yields are more likely to go higher than lower, but they could go lower in the short term.”

BoC will continue to diverge

Policy divergence will continue, say both experts.

Sagoo notes, “BoC Governor Stephen Poloz had been remarkably dovish in his comments and is very wary of having the dollar run higher,” due to his goal for exports and the economy. But, Sagoo adds, “Even though Poloz wants a softer dollar, he may not be able to continue to talk it down given the good spate of economic data.”

Read: The BoC’s unofficial lower-loonie policy

But don’t expect a rate cut.

“The BoC does have a habit of going against the grain and cutting rates at unexpected moments, as they did during the oil crash, so to say they wouldn’t cut rates would be a fool’s errand,” says Sagoo. Still, more fiscal stimulus details are expected and there’s not enough weakness in the economy to warrant such a move at this point.

For example, he adds, we’d need another 20% to 30% oil price decline to pave the way for “digging down” and making a cut.

Other reactions

• In a research note, CIBC World Markets director Royce Mendes says, “The wording in the [Fed’s] statement was only marginally changed […] The committee did give a nod to the fact that the inflation target is symmetric, which could have some market participants pricing additional odds of a slight overshoot. However, we continue to believe that inflation will reach and stabilize around target over the course of the next two years.” The bank also expects only two more hikes.
• A research note from RBC Capital Markets says, “This marked the […] shortest period between increases at just three months. The FOMC remains confident that the economy will continue to grow, […and] this confidence was evident in the forecast supplied with the statement that showed the median growth forecast at 2.1% in both 2017 and 2018,” which is solidly above the 1.8% longer run estimate, despite two hikes this year and three next year.
• Nigel Green, CEO of deVere Group, says, in a release, “[…] We’re in a new era of higher inflation and higher interest rates.” So, investors need to ask themselves whether their portfolios are diversified, and whether they’re prepared for inflation to inch up and dollar swings.
• James Laird, co-founder of RateHub.ca, says, “The quarter-point increase in the U.S. Federal interest rate typically results in the same increase for fixed rate mortgages here in Canada, which we should expect to see in the coming weeks. This rate increase comes the same week as higher mortgage insurance premiums take effect.” Overall, he adds, the Fed’s move doesn’t put more pressure on the BoC.