Last week's strong employment report makes it almost certain the Federal Reserve (Fed) will increase interest rates by 25 basis points (bps) at its meeting this Wednesday. The February employment report showed strong gains in job creation. Non-farm payrolls increased by 235,000 for the month, which was stronger than the expected 200,000 increase and surpassed the average increase of 180,000 for the past six months. As a result, the unemployment rate decreased by 0.1% to 4.7%.
The big question now is given the uptick in growth, employment and inflation and the new administration’s pro-growth policies, is the Fed behind the curve in increasing rates? Evidence is building to support this argument—maybe as much as 1%. Don't forget the Fed is still providing significant monetary policy with its balance sheet of roughly $4.5 trillion in securities. We get another look at inflation on Wednesday with the release of the consumer price index (CPI). Despite the recent drop in energy prices, most data supports increasing inflationary pressures.
The economy still has a lot of monetary stimulus, and if the new administration is successful in implementing its fiscal stimulus policies the Fed may have to speed its pace of rate increases. In the short term, the stimulative monetary policy supports increasing equity prices, but if the Fed signals a quickening pace of interest rate increases, it could pressure equity valuations. I still think bonds are vulnerable to declining prices in this environment. The shape of the yield curve will be most impacted by the pace of Fed increases. A slower pace is worse for long bonds, while a quicker pace is worse for short maturities.
I will be closely watching the commentary from the Fed at its Wednesday afternoon news conference. I'll also be keeping a close eye on the U.S. dollar versus the pound and yen, as both the Bank of England and Bank of Japan will be making monetary policy announcements this week.
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