The Federal Reserve’s Federal Open Market Committee (FOMC) hiked its federal funds policy rate by a quarter point, as widely expected by financial markets.
Recent US domestic economic activity data has been encouraging enough to underpin this upward revision and, although there is unlikely to be any precise detail on US fiscal policy before Trump’s inauguration in January, it is clear that some degree of fiscal loosening is on the agenda, Daniela Russell, portfolio construction associate at LGIM, noted following the Fed’s announcement.
Rick Rieder, CIO of Fundamental Fixed Income at BlackRock, said that “central banks are now heading down more appropriate policy paths, and markets will continue to respond accordingly”.
The more aggressive interest path of the Fed pushed bond yields in the US and Eurozone sharply higher. According to Kim Lubbers, portfolio manager at Kempen Capital Management, the increase in fiscal spending, more likely in the US than in the Eurozone, and the decline in monetary accommodation will probably lead to a further increase in bond yields in the next months.
“However, you can question if all countries can cope with much higher yields without inflating away their debt or defaulting,” Lubbers said.
Rieder, for his part, said risk markets are likely to be well supported, rates can move moderately higher, inflationary expectations can continue to accelerate, and economic and financial investment can and will grow alongside of this.
“That’s not to suggest that this progress won’t have setbacks, and other bouts of political risks could well jolt markets in the year ahead, but we believe alongside higher levels of volatility, markets will be encouraged by a more sensible policy mix that stands a better shot of improving growth prospects for a broader population,” Rieder said, adding that, from an investment perspective, TIPS (breakevens) “look much more attractive than nominal Treasuries at this stage”.
Pioneer Investments’ head of Investment Management Ken Taubes, highlighted that US economy is currently benefiting from the highest consumer confidence since the financial crisis, an improving global economic backdrop, and increasing commodity prices.
“With Trump’s proposed pro-growth economic policies and his pro-business Cabinet, we believe the potential for higher growth and inflation is strong. We continue to be positioned for rising interest rates and inflation in the wake of a stronger economy,” Taubes noted, adding that Pioneer now favours credit markets over US Treasuries.
“Corporations may benefit from lower taxes, less regulation and higher growth. Within corporates, we favor financials and energy,” Taubes said.
Three rate hikes next year
The December rate increase represents the sole rate increase for 2016 and the second increase in 10 years, but what surprised markets is that the FOMC projected three rather than two rate hikes of 0.25% in 2017.
“This could well be the realization of reflationary potential being a bit stronger today than a few months back,” Rieder noted.
According to Russell, the key risk to the current reflation trade is that credit conditions tighten faster than economic growth is improving.
“Therefore, given our concerns over the structural vulnerabilities associated with the global debt overhang, we believe it is prudent to remain cautiously positioned across global credit portfolios,” she said.
David Absolon, investment director at Heartwood Investment Management, noted that although the Fed went slightly more hawkish in projecting the future interest rate path, it is no game changer.
“The market reaction in the next few days is not irrelevant, but it will be in January to see whether the market has over-tightened financial conditions,” Absolon said.