The Fed Launches Rates – Finally
First Western Investment Research
December 17, 2015
The Federal Reserve Board made a momentous, though not unexpected call yesterday, in announcing the end to its historic seven-year-long zero interest rate policy. Although we had anticipated this move in September, we’re pleased that the Fed is finally taking steps toward normalizing rates. The economy has long since moved beyond the crisis environment that originally necessitated zero-rate policy. And it’s 2 ½ years since then-Fed Chair, Ben Bernanke, made his famous speech regarding the planned tapering of quantitative easing.
We view the Fed’s unanimous decision to lift the Fed Funds rate by 25 basis points as a vote of confidence in the economy’s ability to show moderate growth even with interest rates slightly higher. The dovish language in Fed Chairwoman Janet Yellen’s statement regarding future interest rate increases was certainly soothing to the markets. Yellen noted that the Fed’s interest rate policy “remains accommodative” to growth and will require “only gradual increases” over next few years. The Fed will continue to assess economic developments and data and act based on that data rather than having a calendar-driven rate schedule.
The Fed’s two primary mandates, employment and inflation, have been moving in opposite directions. The labor market has been strong with unemployment having fallen to 5% and wages are showing early signs of gaining upward momentum. Inflation, on the other hand, is running well below the Fed’s 2% target. Yellen reiterated her Committee’s confidence that inflation will rise in the medium term and that commodity price weakness is transitory.
The Fed’s move sparked a strong rally in stocks as there was general relief that the Committee saw the economic environment, including credit markets and global economies, as able to withstand moderately higher rates.
The Fed’s 25 basis point move has been part of First Western’s base case outlook for 2016. We expect at least three additional increases next year which would bring the Fed Funds rate to 1%. We would anticipate that the longer 10-year Treasury bond would rise to just under 3% from its current 2.25% by year-end 2016 based on that scenario.
Stocks have had a history of performing well during the year following the launch of rate increases. This stems from the correlation of a lift-off on rates and economic growth. So investors should not fear the market in the face of the Fed’s rate hike but, rather, see it as an endorsement of confidence in our economy and corporate profits. Clearly, Yellen believes there is little danger that the growth in the economy will reverse course. We concur and, in fact, believe growth could pick up a little in 2016.
Stock valuations are based on earnings and what level of price earnings ratio investors are willing to pay for those earnings. In today’s fairly valued market we believe that growth will be sufficient to propel stocks higher, but likely by only mid-single-digit returns next year.
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