Nicholas Zaiko, CIMA
Senior Consultant
Bridgebay Financial, Inc.
The
U.S. economy is poised for stronger growth, higher corporate profits, improving
wages, and inflation returning to normal levels. The Federal Reserve is
responding by accelerating its monetary tightening and projecting that it will
raise Fed Funds rates three times in 2017.
Changes in U.S. federal policies for 2017 include potentially lower
personal taxes, corporate tax rate reductions, increased fiscal stimulus, and
infrastructure spending should all favor growth.
U.S. Federal Reserve
On
December 14, 2016, the Federal Reserve increased the Fed Funds from a target
rate of 0.25% to 0.50% to a range of 0.50% to 0.75%. The last rate hike was
December 16, 2015. The FOMC cited
inflation and strong labor markets as grounds for the rate increase. If labor
market conditions continue to improve the unemployment rate is expected to be
4.5% in late 2017.
The
Fed is reflecting its confidence that the U.S. economy is strengthening by
forecasting 3 rate hikes in 2017 ending the year at 1.25% to 1.50% Fed Funds
rate. A tight labor market and firming
inflation in the U.S. should allow the Federal Reserve to continue to slowly
raise rates.
The
Fed expects inflation to rise more than previously forecasted due to the a new
fiscal stimulus program being considered by Congress under the new Trump
administration. The FOMC expressed
"considerable uncertainty" about the economic impact of the Trump
administration’s stimulus plans and potential increase in government debt to
fund those programs.
U.S. Interest Rates
Since
the November, 2016 election and Fed Funds rate increase, yields have risen
across the curve. The long-end of the
yield curve flattened slightly. The 4th
quarter was dominated by market reactions to the Trump victory which helped to
sharply increase inflationary expectations, leading to a surprising rise in
rates. Rising rates may lead to increased short-term volatility in fixed income
markets. Interest rates should rise in
2017 but only at a modest pace due to sluggish global growth and very cautious
global central banks. The U.S. 10-year
Treasury yields rose to 2.50%–2.60% range in December, a substantial move from
the low yield of 1.36% in July, 2016.
The
10-year Treasury is expected to be at 3.0–3.5% by year-end 2017. The strong U.S. dollar may move higher
against major currencies due to higher U.S. rates and a potential repatriation
of corporate cash from offshore portfolios.
U.S. Economy
The
U.S. is in economic expansion as 3% GDP growth is possible in 2017, even if job
growth slows down. December, 2016 was
the 75th straight month that U.S. employers added jobs with less slack in the
labor market putting upward pressure on wages. In December, 2016, average
hourly earnings for private-sector workers advanced 0.39% from November.
Although job creation slowed, growth in wages was the strongest since 2009 as a
result of the tightening labor market.
Nonfarm
payrolls rose by a seasonally adjusted 156,000 in December from the prior
month. The unemployment rate rose to 4.7% from 4.6% in November, reflecting
more Americans entering the labor force. Economists expected 183,000 new jobs
and a jobless rate of 4.7%. The broader measures of labor market slack are
expected to remain tight in 2017.
With
the years of low interest rates, consumers have repaired their financial
condition and household wealth. A
personal tax cut could further add to demand in the economy.
International
trade should continue to be a net drag on the U.S. economy because of a high
dollar. Congress may pass some tax cuts and additional infrastructure and
defense spending in 2017, further boosting an already growing budget deficit.
Stronger
U.S. economic growth, inflation, increased fiscal spending and larger
government deficits are negative for fixed income markets.
Central Banks
2017
may see the end of global central bank easing and a positive normalization in
interest rates and inflation. Global central banks are acknowledging that they
are out of monetary policy tools. The outlook for developed markets remains
modest but steady. Increasingly sound economic fundamentals supported by U.S.
and European policies should help offset weakness in the United Kingdom and
Japan.
Policy
rates for the U.S. and the UK are projected to rise gradually. Most developed economies are likely to
struggle to consistently achieve 2% core inflation over the medium term. Further monetary stimulus is unlikely, as the
benefits are waning and, in the case of negative interest rates, can prove
harmful to the economies that monetary policy attempts to stimulate. The
European Central Bank and Bank of Japan each implemented additional
quantitative easing in 2016 and are unlikely to raise rates this year.
The
Bank of Japan pledged on September 21, 2016 to keep 10-year Japanese Government
Bond (JGB) yields near zero. The Bank of Japan has proven itself to be the
boldest in pushing the boundaries of monetary policy. Although a recent pivot
by the government toward fiscal policy and longer dated yield targeting implies
the central bank may begin to step aside, the policy rate is expected to fall
slightly deeper into negative territory.
European
bonds were volatile on speculation over the European Central Bank (ECB)
quantitative easing (QE) plans. On
December 8, 2016, the ECB announced that it would extend the QE bond purchase
program. European rates are expected to become less negative.
Central
banks across the globe have reached a critical stage and are hitting the limits
of monetary policy, which is leading to diminishing benefits and increasing
risks with negative interest rates.
Negative interest rates have had a damaging impact on the banking
sector. Europe is experiencing slow but steady growth. Japan is stabilizing and will curtail
additional stimulus.
Risks
The
populist tide in the UK’s Brexit and the U.S. Trump win is a global phenomenon.
Elections in 2017 in France and Germany may cause key economies to adopt
nationalistic and trade-protectionist policies.
Developed countries may implement significant fiscal expansion plans
that may increase the global amount of government debt.
Growing
global debt, the rise of political populism and geopolitical threats all still
highlight potential risks. Populist politics and anti-globalization sentiment
have set the stage for significant policy change in 2017 and beyond.
Possible
protectionist trade policies could lift consumer prices by raising the cost of
imports. Rising energy prices also helped boost headline inflation. Higher
inflation prospects mean that the Fed would tighten monetary policy by raising
rates.
Modest
rate increases in 2017 may create a more challenging environment for fixed
income investing. This rate hike cycle will be more difficult than the last.
Rates are rising from extraordinarily low levels and fixed income investors
will not have the high interest coupons to offset potential capital
depreciation as rising rates lead to falling bond prices.
