Fed has finally started to hike rates

US Central Bank raised its key interest rates by 25 basis points, first hike in almost 10 years. The quarterly outlook on unemployment, economic growth and inflation was basically unchanged.

The Federal Open Market Committee (FOMC), the Fed’s interest-rate setting body, hiked the federal funds rate by 25 basis points on 16 December. This was widely expected by economists (of 57 economists surveyed by Bloomberg ahead of the meeting, only one expected no change) and the interest forward markets. The decision was undisputed and the vote was unanimous. At the same time, the Fed stressed that it expects only “gradual adjustments in the stance of monetary policy”.

… as the FOMC sees more progress on the labour market
The key changes in the yesterday’s FOMC statement compared with that of October were: “A range of recent labor market indicators, including ongoing job gains and declining unemployment, shows further improvement and confirms that underutilization of labor resources has diminished appreciably since early this year.” The Fed is aware that inflation and inflation expectations are low but it continues to expect inflation to approach 2 percent “…over the medium term as the transitory effects of declines in energy and import prices dissipate”.

Fed members lowered their key interest rate forecasts again, but only marginally
After lowering their “appropriate pace of policy firming” in the past two quarters, the Fed members left their forecasts unchanged compared with those of the September meeting for the end of 2016. For the end of 2017 and 2018, the median of the appropriate policy rate were once again marginally reduced to around 2.6 percent at the end of 2017 and 3.4 percent at the end of 2018.

Impact on Vontobel forecasts
We leave our forecast for the federal funds rate and the 10-year bond yield unchanged. The Fed rate forecasts imply one rate hike per quarter in 2016, resulting in a total rate hike of a full percentage point. Our forecast implies three rate hikes or a total of 0.75 percentage points. Compared with earlier rate-hiking cycles, this is extremely moderate. The latest rate cycle from June 2004 to June 2006 consisted of 25 basis points at each meeting, i.e. 2 percentage points per year. By historical standards, this interest-rate cycle was already amongst the slowest on record. The slow rate hikes are justified by the asynchronous global business cycle, with higher unemployment rates and lower inflation abroad. In addition, the strong US dollar has a disinflationary impact.

Market impact and positioning
The Fed decision to raise interest rates was well telegraphed in advance so that the market impact has been subdued thus far. This is particularly true for the US yield curve, which has been remarkably stable, despite the fact that the U.S. Federal Reserve’s own projections point to more rate hikes over 2016 and 2017 than most market participants expect.

The main issue for the markets remains the deterioration of credit quality across commodity producers and their suppliers, on the back of both a further decline of commodity prices and aggressive cuts in capital expenditure. We still doubt that such developments could drag the global economy into a recession.

Comment by Christophe Bernard, Chief Strategist di Vontobel