Fed Watch: Take a Hike

Head of Fixed Income Strategy
Follow Kevin Flanagan

Unless the Federal Reserve (Fed) offers up an unexpected curveball to the markets at today’s FOMC meeting, investors will be presented with a new setting to begin calendar year 2017: a Fed Funds target that is 25 basis points (bps) higher than where we’ve been operating over the last 12 months. In a somewhat rare development, the implied probability of a rate hike at this Fed gathering has been placed at 100% for the last three weeks. Thus, if the voting members follow through on this expectation, the money and bond markets will quickly pivot to any hints the Fed may provide as to what the outlook for 2017 monetary policy may be.
Going back to our “Fed 101” textbook, the December FOMC meeting will contain the usual accompanying policy statement, the Fed’s updated Summary of Economic Projections (SEP) as well as Chair Yellen’s press briefing. In other words, the markets will have plenty of headlines to digest in relatively short order, and as we have seen in the past, this much Fed-related input can be subject to potential misinterpretation if the policy makers try to fine tune their message too much, especially when compared to what has already been discounted by the U.S. Treasury (UST) market. As we witnessed just last week following the European Central Bank’s (ECB) meeting, an unintended market reaction can accompany any monetary policy announcement. Indeed, based upon ECB President Draghi’s post-meeting presser, it would appear the ECB was not trying send a “taper” message to the bond markets, but that was nonetheless the initial interpretation.
This is essential to how the Fed frames this expected rate hike. According to the yields currently in place in the Treasury market, one could make the case that the UST market has not only discounted such a move but continues to see two additional increases in 2017, an expectation that aligns with the Fed’s own median forecast, which was presented following its September gathering. In addition, based upon post-election “Fed speak,” Fed officials have continued to emphasize that their policy outlook, at least for now, can’t be based upon potential fiscal stimulus that has not even been signed into law. Thus, while the UST market has certainly been repriced for this potential, the FOMC appears to be taking more of a wait-and-see approach.
So, where should investors focus their attention at 2:00 p.m. eastern time? Let’s look at the policy statement first to see what changes are potentially made to the Fed’s language guidance. The key phrases utilized at its November meeting were “the case for an increase in the Federal Funds Rate has continued to strengthen,” and “near-term risks to the economic outlook appear roughly balanced.” Obviously, if the target for overnight money has been lifted, the former will either be altered or removed altogether, while the latter  will be looked to for any shift in the policy makers’ thinking for early 2017. At the same time, the market focus will be on the “Blue Dots” (the Fed’s median forecast) to see if there has been any change to the expectation of two rate hikes for next year.
Looking at the makeup of the FOMC, the membership is already short two Fed governors. Thus, as the annual rotation occurs among the Fed bank presidents, President Trump will have the opportunity to fill the aforementioned governor voids. Should these moves affect the outlook for monetary policy in 2017? More than likely, the answer is no. Typically the FOMC follows the lead of the chair, with the vice-chair’s and the New York Fed president’s views also carrying some weight, and “the names here will remain the same.” The bottom-line message seems to be that Fed policy will most likely begin the next year by maintaining a gradual, deliberate approach to rate hikes and will respond to potential fiscal stimulus once it’s actually in place and the data warrant additional action.

Important Risks Related to this Article

Fixed income investments are subject to interest rate risk; their value will normally decline as interest rates rise. In addition, when interest rates fall, income may decline. Fixed income investments are also subject to credit risk, the risk that the issuer of a bond will fail to pay interest and principal in a timely manner or that negative perceptions of the issuer’s ability to make such payments will cause the price of that bond to decline.
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About the Contributor
Head of Fixed Income Strategy
Follow Kevin Flanagan
As part of WisdomTree’s Investment Strategy group, Kevin serves as Head of Fixed Income Strategy. In this role, he contributes to the asset allocation team, writes fixed income-related content and travels with the sales team, conducting client-facing meetings and providing expertise on WisdomTree’s existing and future bond ETFs. In addition, Kevin works closely with the fixed income team. Prior to joining WisdomTree, Kevin spent 30 years at Morgan Stanley, where he was Managing Director and Chief Fixed Income Strategist for Wealth Management. He was responsible for tactical and strategic recommendations and created asset allocation models for fixed income securities. He was a contributor to the Morgan Stanley Wealth Management Global Investment Committee, primary author of Morgan Stanley Wealth Management’s monthly and weekly fixed income publications, and collaborated with the firm’s Research and Consulting Group Divisions to build ETF and fund manager asset allocation models. Kevin has an MBA from Pace University’s Lubin Graduate School of Business, and a B.S in Finance from Fairfield University.