Markets & Economy

The Federal Open Market Committee (FOMC) unanimously decided to increase the federal funds target rate by 25 basis points last week, moving the target range from 0.25–0.50% to 0.50–0.75%. This is the second rate hike in over a decade; the federal funds target rate was last raised in December 2015, also by 25 basis points.

Although financial markets fully expected the increase, the Treasury market experienced a strong selloff after the FOMC revealed a few surprises:

• The Dot Plot: Released after every FOMC meeting, the December dot plot indicates where each FOMC member believes the federal funds target rate range should be at the end of each calendar year through 2019 as well as over the longer run. The FOMC increased its median projection for the number of federal funds rate increases in 2017 from two to three. Most market participants didn’t expect this; they had expected the FOMC to continue projecting two increases. Additionally, the FOMC’s economic projections included a marginal increase in projections beyond 2019, which is notable, as the projection for this period has been consistently falling even after the Fed began to normalize monetary policy.
• High Pressure Economy: During her press conference, Fed Chair Janet Yellen emphasized that she never said she favors running a high pressure economy, but that her comments in a previous speech were that it warranted research. A high pressure economy is where the unemployment rate is allowed to fall below its noninflationary minimum for some time before pushing rates up. This would allow the economy to reverse some of the supply-side damage from the financial crisis. The bond market views this idea of running a high pressure economy as negative for bonds, as it would allow inflation to increase. Yellen’s clarification led to the market factoring in a faster rate of increases than previously believed.
• Unemployment: The Committee’s longer run expectation for unemployment remained unchanged at 4.8%, despite the fact that the unemployment rate has fallen to 4.6%. We believe this implies that the FOMC thinks there is limited slack left in labor markets (i.e., that the quantity of labor and capital that could be employed productively, but isn't, has narrowed considerably) and so is starting to take steps to prevent overheating and inflation.

We were initially surprised the Committee increased the expected number of federal funds target rate hikes for 2017. During the press conference, Chair Yellen noted that “some but not all” Committee participants had factored fiscal policy assumptions into their new projections. This was unanticipated because President-elect Trump’s policy agenda was not expected to be factored into FOMC projections until details of the policy became known. Additionally, only a small number of members changed their projections, but it was enough to lead to a change in the median projection.

Although we do not believe a change in the projected number of federal funds target rate hikes is of utmost importance, these events were enough to induce yet another flurry of activity in the U.S. Treasury market. The 2-year Treasury jumped from 1.17% on December 13 to 1.27% the day of the rate hike. The last time the 2-year yield was at this level was back in 2009, shortly following the financial crisis. Meanwhile, the yield on the 10-year Treasury reached levels last seen in 2014; however, the spread between 2- and 10-year Treasuries has increased, generally indicating that the market is pricing in a higher level of future growth and inflation.

We feel it wouldn’t be unreasonable for yields to pull back once the euphoria that’s gripped the market over the past month and a half starts to dissipate. However, we still believe that bond yields will continue rising gradually over time.

Although a yield increase can weigh on current performance, it may benefit future performance since higher yields can improve valuations and lead to higher income and return potential over time. An active approach to managing interest rate risk can help appropriately position portfolios for rising or falling yields, which should serve to benefit returns. At Manning & Napier, we are looking to help clients take advantage of higher bond yields by using an active approach to reinvest the proceeds from maturing securities at higher rates in short-term fixed income portfolios and incrementally increase the duration of intermediate- and long-term fixed income portfolios over time to lock in higher levels of income.