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Rising Interest Rates

Written by: Frank Fazio

Last week the Federal Reserve voted to raise their benchmark rate by 0.25%, moving from .5% to 0.75%. This was third rate hike in a little more than a year, and the second since December 2016. The last time the Fed raised rates at consecutive quarterly meetings was back in 2006, when they increased rates in March and then again in June.  Although the odds of an increase in rates were low as this month began, rising inflation data and a strong jobs report allowed the Federal Reserve to communicate their desire to raise rates prior to their formal meeting.  In her post-meeting press conference, Janet Yellen stressed the continuance of accommodative monetary policy to promote economic growth. This caused longer term bond yields to decline, as the market expected the Fed to shift towards tighter monetary policy.  Still, they maintained their outlook of a gradual rise in the Fed Funds rate over the next several years, with a forecast of at least two more rate hikes this year and three next year.

The odds of a rate increase rose to near certainty after comments from Yellen and other Fed Bank Presidents along with a strong labor market report.  Wages continue to trend higher, which supports consumption that drives our economy.  However, increasing wages typically comes at the cost of higher inflation.  Consequently, recent inflation data rose close to the Federal Reserve’s target of 2%, which is the highest level since 2012.  Therefore, we continue to expect at least one more rate hike this year with the potential for more if economic conditions continue to improve.  In fact, market expectations have converged with the Federal Reserve’s forecast of three increases this year, although odds of a June hike have dropped from 80% to 50% since last week’s vote.

Despite the uptick in short term rates, longer term rates recently declined as the 10-year Treasury rate fell 10 basis points over the past week to 2.43%. This may be transitory, as the market weighs the probability that President Trump’s pro-growth policies are delayed or altered due to gridlock in Washington.  Still, recent economic data supports our belief that the economy is strengthening, which should result in higher short term and intermediate term interest rates as we move through 2017.   In fact, we reviewed the last three major tightening schedules (‘94/95, ‘99/00, & ‘04/06), short term government bond yields (as measured by 6-month T-Bills through 2 Year Treasury Notes) rose an average of 1.5-2% while longer term rates (10-year & 30-year Treasury Bonds) rose an average of 0.4-0.6%. Although we have yet to see a meaningful uptick in short term yield instruments (i.e. CDs, Money Markets, savings accounts), we expect yields to rise over time as a higher rate environment results in greater profitability for banks.    This will ultimately help retirees and savers, as short term yields move off the historically low levels we have experienced since the financial crisis.