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Fed continues waiting game on interest rate hike

4 November 2016 in Investing Insights

Key Takeaways:

  • The Federal Reserve will likely raise interest rates at its next meeting in December
  • Stocks stand a good chance of absorbing any increases in stride

The Federal Reserve did with interest rates this Wednesday what everyone expected it to do: nothing. Falling just six days before a tumultuous presidential election comes to an end, the central bank’s November meeting was long seen as an event where the Fed would refrain from any policy change that would stress financial markets.

The lack of a move this month adds much anticipation to the Fed’s next meeting in December – post election – when everything it said on Wednesday and before points to an interest rate hike. A fairly positive jobs report on Friday [1] strengthened those arguments.

The Fed noted [2] continued progress across the economy as the justification for such a rate hike, all of which it also highlighted at its September meeting: hiring grew, incomes rose, output picked up, and inflation is running higher than earlier in the year. Optimism about the third quarter, which measured out to impressive 2.9 percent GDP growth, is tempered by qualifiers the Fed put down in its statement this week: Business investment is still “soft,” inflation is below the Fed’s 2 percent target, and the economy is only expected to grow at a “moderate” pace. Don’t get too excited, we’re cautioned.

Because of such a mixed reading about the economy, the Fed is only expected to raise interest rates 25 to 50 basis points at its next meeting. This is what it did in December 2015, and markets took it in stride (the S&P 500 [3] is up 1.1 percent since that date, and is about 4 percent off its current 52-week high). The futures market places the likelihood of a rate hike for this December at 78 percent [4]. Stocks may not cheerlead such a move, but there’s little evidence they will be harshly affected by it.

Something else the Fed said at the end of Wednesday’s statement [5] carries an outright bullish implication for investors. Here’s the paragraph in full, which we translate below:

“The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction, and it anticipates doing so until normalization of the level of the federal funds rate is well under way. This policy, by keeping the Committee’s holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions.”

What this means is that the Fed is continuing its aggressive response to the 2009 financial crisis and aftermath with regard to its own balance sheet. It is buying fixed income securities — specifically, government bonds — and will continue to do so until it starts raising interest rates aggressively. This policy frees up trillions of dollars in investor demand because the Fed is buying financial assets that investors would otherwise buy. As long as this continues — and the Fed indicates it will for a while — it’s good news for stocks and bonds. Stay tuned.

[1] Bureau of Labor Statistics, “Employment Situation Summary,” November 4, 2016.

[2] Board of Governors of the Federal Reserve System, “Press Release,” November 2, 2016.

[3] “S&P 500 (^GSPC),” Retrieved from Yahoo! Finance, November 2, 2016

[4] CNBC, “The Federal Reserve Looks Ready to Roll with an Interest Rate Hike in December,” November, 2, 2016

[5] Board of Governors of the Federal Reserve System, “Press Release,” November 2, 2016.