Federal Reserve Rate Hike #2

The Federal Reserve will likely raise short-term interest rates this week, when it convenes the last policy meeting of 2016. The second rate hike of the cycle comes one full year after the first, nine years after the last time it had previously raised rates. The central bank is probably more confident about this action than it was a year ago, because it will occur after the President-elect indicated that there would likely be a new boost to the economy, in the form infrastructure spending, tax cuts and deregulation. While GDP averaged a fairly subdued 2 to 2.25 percent during the recovery thus far, the potential Trump actions have prompted economists to increase their estimates for 2017 to 2.5 to 3 percent. Economists and investors will be paying close attention to any mention of how the FOMC may change its outlook in response to the major fiscal stimulus that will likely be enacted. A faster growing economy could mean that the Federal Reserve will finally see its much-desired pick up prices and as a result, the central bank should be gearing up for a series of rate hikes in 2017.

Here’s the rub: for all of candidate Trump’s complaining about Janet Yellen’s Fed keeping rates too low for too long, the biggest risk to the current expansion would be if the Fed were to move more quickly than anticipated, putting the current stock market rally at risk and potentially sparking a recession.

Fear not…current Fed officials appear to on track to under-deliver on their inflation target, as they have done consistently over the past twenty years. That’s why Yellen has been so willing to be patient on raising rates. Although Trump took aim at Yellen for not raising rates faster, she may in fact be the ideal Fed Chair to keep the economic expansion/stock market rally alive in 2017.

HOW WILL THE FED’S ACTIONS IMPACT CONSUMERS?

Savings: Any increase in the Fed Funds rate could help nudge up rates on savings accounts, but after the first increase, banks passed very little of the increase on to their customers. Bottom line: savers’ suffering is not likely to end any time soon.

Mortgages: While rates for fixed rate mortgages key off the 10-year government bond, not short term rates that the Fed controls, yields have already started to rise since the election. The average contract interest rate for 30-year fixed-rate mortgages with conforming loan balances ($417,000 or less) increased to 4.27 percent, the highest level since October 2014 and up from 3.5 percent before the election. Adjustable rate mortgages (ARMs) are linked to shorter-term rates, which means that consumers should be careful about assuming these loans and also should consider locking in a fixed rate now. Those who have ARMs could see payment increases down the road.

Auto Loans: For those planning on purchasing a new car with a loan, don’t worry too much. An extra quarter-point increase on a $25,000 loan amounts to a few dollars a month in higher payments.

Credit Cards: Most credit cards have variable rates and unlike the savers, the card companies are quick to pass along the increase to the borrowers within a few billing cycles. You may want to consider locking in a zero balance transfer offer, because it won’t be around as the Fed keeps increasing rates in 2017.

Student Loans: Federal loans are fixed, so there will be no impact from a rate increase, but some private loans are variable. Double check your paperwork to determine what benchmark rate (Libor, prime, T-bill) your loan is tied to.

HOW WILL THE FED’S ACTIONS IMPACT INVESTORS?

Stocks: If the Fed goes slowly and the economy improves, the stock market should be fine. But, as noted above, if the central bank ends up raising rates faster than expected, it could hurt prices. In the past, shares of banks, energy, industrials and technology do well amid rising rates.

Bonds: When interest rates rise, bond prices fall and in this particular cycle, it could be even more painful, because the slow growth recovery lulled many bond investors into complacency. That said, there is no reason to abandon the asset class. For most investors who own individual bonds, they will hold on until the bonds mature and then purchase new issues at cheaper prices/higher rates. For those who own bond mutual funds, they will reinvest dividends at lower prices and as the bonds in the portfolio mature, the managers will reinvest in new, cheaper issues with higher interest rates. In other words, being a long term investor should help you weather rising interest rates, though you may want to consider lowering your duration, using corporate bonds and keeping extra cash on hand. (For more on bonds, check out this post.)

MARKETS: There were new records all around, providing more post-election gains. Since November 8^th, the Dow is up 8 percent, the S&P 500 has gained 11 percent and the NASDAQ is up 9 percent.

• DJIA: 19,756, up 3.1% on week, up 13.4% YTD (23^rd record close of 2016)
• S&P 500: 2259, up 3% on week, up 10.6% YTD
• NASDAQ: 5444, up 3.6% on week, up 8.7% YTD
• Russell 2000: 1388, up 5.6% on week, up 22.2% YTD
• 10-Year Treasury yield: 2.47% (from 2.39% week ago)
• January Crude: $51.48
• February Gold: $1,161.40, 5^th straight weekly decline
• AAA Nat'l avg. for gallon of reg. gas: $2.20 (from $2.17 wk ago, $2.01 a year ago)

THE WEEK AHEAD:

Mon 12/12:

Tues 12/13:

6:00 Small Business Optimism

Weds 12/14:

8:30 Retail Sales

8:30 PPI

9:15 Industrial Production

2:00 FOMC Meeting Announcement/Economic Forecasts

2:30 PM: Fed Chair Janet Yellen press conference

Thurs 12/15

8:30 CPI

8:30 Empire State manufacturing survey

8:30 Philly Fed manufacturing survey

10:00 NAHB homebuilder survey

Friday 12/6

8:30 Housing Starts

Go Time for the Fed

Way back in July, Federal Reserve Chair Janet Yellen said: “I expect that it will be appropriate at some point later this year to take the first step to raise the federal funds rate and thus begin normalizing monetary policy.” Well, later this year is here. There are only three Fed policy meetings left in 2015, starting with the two-day confab beginning on Wednesday and concluding Thursday. After delivering that speech, the consensus was that the Fed would increase rates at the September meeting, but a funny thing happened over the past two months: China’s stock market plummeted, raising fears that the economy there had slowed down dramatically; raw commodity prices plunged, which has put global disinflation (a period when the inflation rate is positive, but declining over time) on the front burner; and global stock and currency markets entered a new, tumultuous phase.

All of the sudden, the September rate hike now looks less likely. In fact, traders now only see a 25 percent chance that the Fed will act this week. Of course, Yellen has always kept her options open. In that same speech, she said “I want to emphasize that the course of the economy and inflation remains highly uncertain, and unanticipated developments could delay or accelerate this first step.”

Economists and investors have long been agonizing over the timing of the Fed’s rate hike. Those who advocate action cite the improvement in the U.S. economy: 13.1 million jobs over the past 66 months and unemployment at 5.1 percent, which is lower than the levels seen at the beginning of the Fed’s last tightening cycle in 2004; auto sales running at their fastest pace in a decade; commercial real estate prices surpassing their bubble-era peaks; and residential housing strengthening. That impressive list of accomplishments makes it tough to justify interest rates still being at emergency levels of 0-0.25 percent, which is where they have been since December 2008.

Former Treasury Secretary Larry Summers is the cheerleader for the no-action camp. Last week, he said “Now is the time for the Fed to do what is often hardest for policymakers. Stand still.” Besides global uncertainty, Summers reminds us that part of the Fed’s dual mandate is to promote price stability and with disinflation infecting emerging markets and U.S. core inflation remaining stubbornly low, he is advocating that the Fed do nothing at this time.

All of this may seem like navel-gazing to you, but if the Fed is too late in raising rates, inflation might rise. According to Paul Ashworth of Capital Economics, “Historically, central banks have mostly erred on the side of raising interest rates too little and too late. The result is that inflation starts to spiral out of control, eventually forcing a more aggressive tightening of policy than would originally have sufficed.”

Then again, if the Fed acts too quickly, it could snuff out the recovery. Andrew Haldane, the Chief Economist at the Bank of England has noted, “The act of raising the yield curve would itself increase the probability of recession.”

WHAT DOES ALL OF THIS HAVE TO DO WITH YOU?

In the seven years since financial crisis, companies, governments and consumers have gotten used to ultra-low interest rates. Whether the Fed decides to increase rates this week, in October or in December, the low rate cycle is about to conclude. Here’s how it could impact you:

Savers: Any increase in the Fed Funds rate will help nudge up rates on savings accounts, so savers will finally be rewarded. That said, rates will still be low and the likely slow pace of increases will mean that savers’ suffering is not likely to end any time soon.

Borrowers: While rates for mortgages key off the 10-year government bond, adjustable rates are linked to shorter-term rates, which means that consumers should be careful about assuming these loans and also should consider locking in a fixed rate now. Additionally, as rates increase, the availability of 0 percent credit card and auto loans could diminish.

Investors: Typically, stock markets have dipped after the first rate increase, but usually regain their upward momentum, as long as the rate increase is in response to stronger economic activity. Stocks usually top out after the final increase. The last tightening cycle began with interest rates at 1 percent in June 2004 and ended with rates at 5.25 percent two years later. The stock market peaked in October 2007 and you know what happened after that!

Finally, billions of dollars have flowed into global bond markets over the past seven years, as nervous investors sought the safety of fixed income. While few are advocating selling out bond positions, to help protect your portfolio against the eventual rise in interest rates, you may want to consider lowering your duration, using corporate bonds and keeping extra cash on hand. (For more on bonds, check out this post.)

MARKETS:

• DJIA: 16,433 up 2% on week, down 7.8% YTD
• S&P 500: 1,961 up 2.1% on week, down 4.7% YTD
• NASDAQ: 4,822 up 3% on week, up 1.8% YTD
• Russell 2000: 1157, up 1.8% on week, down 3.9% YTD
• 10-Year Treasury yield: 2.19% (from 2.13% a week ago)
• October Crude: $44.81, down 3.1% on week
• December Gold: $1,107, down 1.6% on week
• AAA Nat'l avg. for gallon of reg. gas: $2.35 (from $2.40 wk ago, $3.41 a year ago)

THE WEEK AHEAD:

Mon 9/14:

Tues 9/15:

8:30 Retail Sales

8:30 Empire State Manufacturing

9:15 Industrial Production

10:00 Business Inventories

Weds 9/16:

8:30 Consumer Price Index

10:00 Housing Market Index

Thurs 9/17: 8:30 Housing Starts

2:00 FOMC Decision/Econ Projections

2:30 Yellen Presser

Fri 9/18:

Quadruple Witching

10:00 Leading Econ Indicators

Janet Yellen's 7-Year Itch

Are Fed officials getting the seven-year itch? The central bankers have kept short-term interest rates (the federal funds rate) near zero since December 2008. Back then, the economy was reeling from the financial crisis and was one year into what would become the most severe recession since the Great Depression. Slashing interest rates and purchasing bonds were strategies meant to spur lending and stimulate the economy. Fast-forward seven years and the U.S. economy finally is firming -- growth is accelerating to about 3 percent annually and job creation has picked up. The improvement has allowed the Fed to conclude its bond-buying plan and would seem to indicate that ultra-low rates are no longer necessary. But in minutes from the last Fed policy meeting, officials are struggling to agree on the timing and pace of interest-rate increases, not to mention the best way to communicate their intentions to the public.

At issue is the core problem with normalizing monetary policy: waiting too long to increase rates could lead to inflation and/or could create financial asset bubbles, while moving too quickly could snuff out the recovery. With all of the uncertainty swirling, it is great timing that Fed Chairwoman Janet Yellen will testify before Congress this week on the outlook for the economy and monetary policy.

Fed officials and the rest of the investment community were relieved to learn that the Eurozone approved a four-month extension on Greece’s €240 billion ($273 billion) bailout plan, which was set to expire on February 28^th. The Greek government must submit details by Monday on the reform and budgetary measures it plans to take in order to seal the deal. There are some indications that European officials will be a bit more lenient on the terms going forward, but nothing is set in stone yet.

The extension sets up a looming summer deadline, because it will expire before a €7 billion ECB bond repayment is due. Additionally, there is the overarching concern that anything that occurs in the near-term is noise, because few believe that Greece’s debts, worth over 175 percent of GDP, will ever be repaid in full. That’s why there have been more calls for Greece to leave the euro zone -- the so-called “Grexit”.

A Grexit seems far less ominous today than it would have five years ago. But there would be losers, including euro zone countries, which own about 60 percent of Greece’s debt, the IMF, which holds about 10 percent and the ECB has 8 percent and private investors, who hold about 17 percent. And no doubt there would also be a negative market reaction. But with some time, there could be a more thoughtful way to manage the exit process and limit the systemic repercussions.

Finally, get ready for America Saves Week, an annual opportunity for organizations to promote good savings behavior and a chance for individuals to assess their own saving status. Only about half of Americans actually have a savings plan with specific goals, so clearly there’s a long way to go to get people on board with the celebration.

MARKETS: The temporary Greek deal was enough to push the Dow, the S&P 500 and the Russell 2000 to new records, while the NASDAQ inched within 1.9 percent of its all time high of 5,048 reached in March 2000.

• DJIA: 18,140, up 0.7% on week, up 1.8% YTD
• S&P 500: 2110, up 0.6% on week, up 2.5% YTD
• NASDAQ: 4,956 up 1.3% on week, up 4.6% YTD
• Russell 2000: 1231, up 2.2% on week, up 2.3% YTD
• 10-Year Treasury yield: 2.14% (from 2.02% a week ago)
• April Crude Oil: $50.34, down 4.6% on week
• April Gold: $1,204.90, down 1.8% on week
• AAA Nat'l avg for gallon of regular Gas: $2.25 (from $2.17 week ago, $3.39 a year ago)

THE WEEK AHEAD:

Mon 2/23:

8:30 Chicago Fed Nat'l Activity Index

10:00 Existing Home Sales

10:30 Dallas Fed Manufacturing Survey

Tues 2/24:

Home Depot, Hewlett-Packard, Macy's

9:00 Case Shiller Home Price Index

10:00 Consumer Confidence

10:00 Janet Yellen testifies before Senate Banking Committee

Weds 2/25:

10:00 New Home Sales

10:00 Janet Yellen testifies before House Financial Services Committee

Thurs 2/26:

8:30 CPI

8:30 Durable Goods Orders

Fri 2/27:

8:30 Q4 GDP (2^nd estimate)

9:45 Chicago PMI

10:00 Consumer Sentiment

10:00 Pending Home Sales Index