Neuberger Berman
December 15, 2016
Delivering compelling investment results for our clients over the long term since 1939.

An Extra Hike

Amid supportive data, the Fed makes the expected move, but signals more to come.

Since the summer, central banks have shown signs of dialing back on stimulus. The ECB has talked about tapering and the Bank of Japan in September abandoned aggressive negative rates for a more modest bond-rate targeting program. At the same time, governments appear to be moving toward greater fiscal stimulus in support of economies. Both trends imply a realization that “exotic” monetary policy, while effective up to a point, has meaningful shortcomings.

Fortunately, the developed world has been displaying signs of reflation. The U.K. experienced this the earliest, as post-Brexit breakeven levels on inflation-linked bonds shot up 40 basis points in one week, driven largely by currency depreciation but also by central bank easing in the context of a strong economy. More recently, reflation forces have moved to the U.S., as improving economic numbers and the Trump victory have bolstered equity markets.

Inflection Point on Policy

The Federal Reserve’s latest 25-basis-point move, which comes a year after its last increase, reflects both a retreat from extraordinary policy measures and the beginnings of U.S. reflation. And with the backdrop of strong economic data and record market highs, I’d call it a “happy hike” in comparison to the grim backdrop of the 2015 increase. The Fed is pleased about economic progress, the potential for rate normalization and a narrowing of its expectations gap with the market.

Although delayed from earliest expectations, the rate hike comes a bit earlier than normal in relation to the tepid jobs market. And it hasn’t been forced by inflation trends, as the 10-year U.S. breakeven inflation rate remains below 2.5% (equivalent to the Fed’s 2.0% implied inflation target). Overall, financial conditions remain fairly supportive, even taking into account the recent uptick in mortgage rates and dollar strength, letting the Fed run the economy a bit “hot” to support further reflation.

What does this mean for Fed guidance? In recent years, the Fed hasn’t been particularly accurate in its inflation and growth forecasts, and we’ve seen a consistent drop in equilibrium real short-term rates. However, I believe the numbers have now bottomed and are likely to reverse. At the same time, market expectations have moved closer to those of the Fed, with the central bank now anticipating three 25-basis-point rate hikes in 2017 (up from two in September, which is the market’s current view); the Fed also remains more hawkish for 2018.

Looking to future FOMC meetings, things could get more interesting by March, when the Fed has more information about the new administration’s economic policies. Donald Trump was elected with themes of “putting America first,” shedding regulation and cutting taxes. Over time, the latter two elements could prove stimulative, but tensions over trade could have an offsetting effect and discourage the Fed from taking further action.

Balance from the Fed

Despite the modest acceleration in pacing, I anticipate a gradual approach from the Fed over the next few quarters. There’s been a lot of talk about fiscal stimulus (which some board members took into account in raising rate expectations) but nothing has actually happened yet; and resulting growth could be more stingy than investors expect. Moreover, the risk from Fed policy is quite asymmetrical. A few more bond purchases may not do much, but removing accommodation too quickly could be very negative.

Board members know this, and will likely continue to follow the data (and the bond market) until the evidence is clear that inflation is heading above comfort levels. Once this happens, assuming a reasonably stable economic/political situation, you could see a more hawkish Fed as we move into late 2017 and early 2018.

This material is provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. Information is obtained from sources deemed reliable, but there is no representation or warranty as to its accuracy, completeness or reliability. All information is current as of the date of this material and is subject to change without notice. Any views or opinions expressed may not reflect those of the firm as a whole. Neuberger Berman products and services may not be available in all jurisdictions or to all client types.

This material may include estimates, outlooks, projections and other “forward-looking statements.” Due to a variety of factors, actual events or market behavior may differ significantly from any views expressed. Investing entails risks, including possible loss of principal. Investments in hedge funds and private equity are speculative and involve a higher degree of risk than more traditional investments. Investments in hedge funds and private equity are intended for sophisticated investors only. Indexes are unmanaged and are not available for direct investment. Past performance is no guarantee of future results.

This material is being issued on a limited basis through various global subsidiaries and affiliates of Neuberger Berman Group LLC. Please visit www.nb.com/disclosure-global-communications for the specific entities and jurisdictional limitations and restrictions.

The “Neuberger Berman” name and logo are registered service marks of Neuberger Berman Group LLC

© 2009-2016 Neuberger Berman LLC. | All rights reserved

http://hvst.co/2gCv45j 
More from Neuberger Berman
The most important insight of the day
Get the Harvest Daily Digest newsletter.