What Investors Can Expect from the Federal Reserve in 2017

Penn Mutual Asset Management

January 11, 2017

What Investors Can Expect from the Federal Reserve in 2017 Photo

Penn Mutual Asset Management CIO Mark Heppenstall contributed an article to The Hill where he shared his outlook on what investors can expect from the Federal Reserve (Fed) in 2017.  The post originally appeared on The Hill on 12/31/16 and can be found below.

After years with monetary policy stuck near the zero level, decision makers at the Federal Reserve are preparing the markets for liftoff. Donald Trump’s victory in November changed investor sentiment and prompted a fast and furious negative reaction across fixed income markets. Ten-year Treasury yields have increased 0.7 percent since Election Day and have nearly doubled since the historic lows set in July. Losses have not been limited to the U.S. fixed income assets, as global bond markets have lost more than $3 trillion in value during the selloff.

Trump’s proposals for new fiscal stimulus, an easier regulatory environment and protectionist trade policies have contributed to renewed investor optimism and economic growth. But they also point to higher inflation and pessimism for fixed income investments. Earlier this month, the Fed added to the bearish sentiment by tightening monetary policy for the second time in 10 years. More importantly, the Fed increased the number of expected rate increases for 2017 from two to three.

Before looking ahead, investors need to take a look back at what drove some of the Fed’s decision making in previous years, as well as the Fed’s stated shift, which is telling for where the economy may go in 2017. Since the financial crisis, the Fed has consistently cited low inflation as justification for its extreme caution when raising rates.

Inflation is expected to rise in 2017, which will make the Fed’s previous argument more difficult. Core personal consumption expenditures (PCE)—the Fed’s favorite gauge of inflation—is running below target, but most other measures of inflation are running above 2 percent. Long sought after wage gains are also seeing traction as average hourly earnings trend higher. They now stand at 2.5 percent growth year-over-year. Inflation expectations have also quickly repriced since the election surprise.

In tune with investors, Fed Chair Janet Yellen has shifted her tone since Election Day regarding her outlook for the economy and inflation. In an October speech in Boston, she communicated a desire to create a “high pressure economy” by allowing the unemployment rate to drop below full employment and inflation to run above its two percent goal. In testimony to Congress this month, she warned that waiting to increase the federal funds rate would increase risks of higher inflation down the road and would force the Fed to abruptly tighten.

A strengthening U.S. dollar will likely complicate the Fed’s ability to manage the pace of rate increases next year. The recent Treasury bond selloff has been putting additional downward pressure the China’s currency and fueling liquidity fears in China’s bond markets. China’s defense of the renminbi will require even more selling of its declining stock of Treasury holdings.

While the post-election reaction within the U.S. financial markets has been favorable, the Trump victory has already created stress across much of the emerging world. With Trump’s view that global trade is more of a zero sum game with winners and losers, what “makes America great again” increases risks to many emerging economies dependent on exports. Protectionist U.S. trade policies coupled with dollar strength will make repayment of the $3 trillion in dollar denominated debt of emerging market borrowers more challenging.

The bigger driver for long-term bond performance in 2017 could be the U.S. joining other sovereign borrowers in issuing 50-year or 100-year debt. Treasury secretary nominee Steven Mnuchin has suggested long maturity debt may be the best way to finance proposed infrastructure spending. Issuance of ultra-long securities across the Atlantic was made easy by the European Central Bank’s negative interest rate policy and unprecedented level of quantitative easing. Finding demand for 50-year or 100-year Treasury debt may prove difficult in the midst of the anticipated Fed tightening cycle.

For years, stubbornly low interest rates have disappointed economic forecasters calling for the end of the bond bull market. However, with fiscal stimulus now ready to join the fray, monetary policy in the United States is finally ready for liftoff.

Tags: Viewpoints | Inflation | Federal Reserve | Interest Rate

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The material provided here is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management.

This material is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management.  This material is not intended to be relied upon as a forecast, research or investment advice, and it is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.

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