What I expect from the Fed in 2017

Eric Stein, Co-Director of Global Income

Boston - The Federal Reserve delivered a quarter-point rate hike at the December meeting as expected, but surprised markets with a "dot plot" that forecast three rate hikes in 2017, up from two previously.

So what now? I'm often asked what I expect from the Fed next year, and the short answer is that the biggest potential surprise is a more hawkish Fed than most expect.

I must admit that I was somewhat surprised that the Fed boosted the dot plot at the December meeting. I had expected this to happen at the March 2017 meeting when the market might have more information on the specific policies of President-elect Donald Trump.

That said, I do think we could get more hawkish surprises on the dot plot in 2017. The economy was accelerating somewhat before the election, and inflation and inflation expectations had also been picking up pre-election as well. If we get regulatory reform, tax reform and infrastructure spending from the Trump administration and Congress in 2017 and the economy really gets going, then the Fed is going to hike more than investors expect.

What could make the Fed less likely to raise rates? If we see the dollar continue to strengthen, if growth underwhelms or if we see a shock in Europe given the upcoming political calendar, then that could make the Fed less likely to hike as aggressively.

Following Trump's election, the distribution of economic and market outcomes has widened significantly. I believe something similar has happened with Fed policy. There is potential for more rate hikes, but the distribution is fairly wide.

What makes things really interesting is that Fed Chair Janet Yellen this month said that fiscal policy stimulus is not needed for the U.S. to reach full employment. Of course, the market is positioning for marginal tax cuts and infrastructure spending , so if fiscal stimulus gives an economy essentially already at full employment a further boost, then maybe we will see a monetary offset with tighter Fed policy.

During the slow-growth period following the credit crisis, global central bankers have been practically begging for help from politicians and fiscal policy. Now, we may see fiscal spending in the U.S. and perhaps Japan. It will be interesting to watch the push-and-pull between the Fed and the White House in 2017.

In the presidential campaign, Trump said Yellen kept rates too low, which helped artificially prop up the stock market. We haven't seen any Trump tweets or statements yet on the Fed, but that may change once he's inaugurated in 2017. Trump may push for more hawkish and free-market leaning economists in the Fed. But at the same time, Trump is a real estate investor who likes debt and inflation, so I doubt he will pack the FOMC entirely with uber hawks. This is another interesting dynamic to watch.

Bottom line: So what does all this mean from an investment standpoint? I believe rates and inflation are headed higher in 2017. Therefore, nominal Treasury bonds are unattractive to me. Meanwhile, most of Trump's policies such as fiscal expansion and trade protectionism are inflationary. That's why I like Treasury Inflation Protected Securities (TIPS) that are duration-hedged. Finally, I believe collateralized loan obligations (CLOs) and floating-rate loans are attractive, and I see some pockets of value in high-yield and emerging market bonds.

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