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Heartwood - Thumbs up to the Fed, but now the hard part begins...

First Published 17th December 2015

David Absolon, Investment Director at Heartwood Investment Management, says the Fed communication machine's forward guidance has set the market up well for this hike. Now comes the tricky part.

David Absolon, Heartwood

US equity markets have responded well to the Federal Reserve's first rate hike in a decade, viewing it as a vote of confidence in the US economy. Bond markets were less cheery; the two-year US treasury yield rose to its highest level since 2010, while the US dollar has remained firm.

A variety of views have been expressed by members of the policy rate setting committee, but Janet Yellen, the Fed Chair, has skillfully steered it towards unanimity in raising Interest rates by 25 basis points. There was something for both the doves and the hawks. The language of the monetary statement supported the widely held view that this rate cycle would be "gradual" in a moderate growth environment. The Fed also committed to monitoring "actual" inflation as well as survey expectations to achieve its inflation goal. Furthermore, the Fed made a strong statement about keeping its balance sheet unchanged for a long time.

For the hawks, the infamous 'dots', where policymakers provide their forecasts over a range of economic, inflation and interest rate measures, were little changed, despite speculation that they would be revised lower. Four rate hikes are forecast for 2016, which is in line with September's projections, while forecasts for 2017 and 2018 marginally decreased. Inflation is forecast to return to the target of 2% by 2018. When questioned about the impact of recent energy price falls in the press conference, Yellen seemed unconcerned. She said that the oil price did not need to rebound for higher inflation, it just needed to stabilise; Yellen seemed confident that it would.

The Fed has been steadfast in its view of the economy and inflation, while the bond market has been playing catch up. In September, less than 20% of the market thought that action would be taken by the end of this year as the Fed cited international factors as presenting downside risks to growth. However, strong employment reports in October and November and some improvement in both US and global economic activity helped to shift the market's perceptions of the timing of the Fed cycle.

But the Fed also recognises that the current US expansion is a moderate one and has acknowledged the likelihood of a lower stopping point in this tightening cycle- the 'neutral' rate. Acting now enables the Fed more flexibility to move gradually and, importantly, to respond to both negative and positive shocks- i.e. the ability to lower interest rates or raise interest rates more quickly if inflation overshoots the target.

In our view, and at the time of writing, the Fed communication machine gets a 'thumbs up'. Its forward guidance has set the market up well for this hike. Now comes the tricky part. We are data dependent. And that means we are likely to see more volatility next year as the consensus of a 'gradual rate rising cycle' will be tested at times as the data waxes and wanes.