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Fed Holds Steady on Rates: Can We Expect a Rate Hike by Year-End?

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NATHAN PETERSON: Hello, and welcome to the Schwab Market Snapshot for November 3. I’m Nathan Peterson, sitting in for Randy Frederick.

The Federal Open Market Committee met this week and, as expected, kept its benchmark rate unchanged. Now, there’s only one meeting left in 2016, and investors may be wondering whether the Fed is still on track to get a rate hike in this year. Today, I’m joined by Collin Martin, a fixed income strategist with the Schwab Center for Financial Research, who will give us his take on yesterday’s FOMC meeting and what investors can expect when they meet again in December. Welcome, Collin.

COLLIN MARTIN: Hi, Nathan. Thank you for having me.

NATHAN: So, Collin, what was your take on the policy statement from the Fed yesterday? And how likely is it do you think that they’re actually going to raise rates in December?

COLLIN: We do think it’s likely that the Fed will hike rates at its December meeting—since that’s what they have been hinting at for the past few meetings. Now, the most recent statement reiterated the case that they can hike rates soon and that the case for that has continued to strengthen. And that for the time being they’re just waiting for some further evidence that they’re making progress on their objectives. Now, what wasn’t in the meeting was any mention that a Fed rate hike might happen at the next meeting. Now, that’s what we got prior to the December 2015 meeting, when they actually did hike rates. So there was no calendar-based guidance in there. Now, that being said, economic data does continue to improve, employment growth remains strong and we’re starting to see signs of wage growth, and inflation, which is the other part of the Fed’s dual mandate, continues to trend higher. The Fed’s preferred measure of inflation is the core PCE Index, and that was up 1.7% year-over-year in September. That matches its two-year high. And the Fed acknowledged the movement in inflation, and that they removed the sentence that they expect inflation to remain low in the near-term—which is likely a result of the stabilization in energy and commodity prices.

NATHAN: So it appears that a rate hike is likely. Now, let’s talk about the outlook as we move into 2017. What do we expect from the interest rate outlook as we move past this December meeting, and what exactly does that mean for investors?

COLLIN: Well, ultimately, we think it’s going to be a very gradual pace of rate hikes. The median FOMC projection for 2017 points to two rate hikes. Now, we don’t make official forecasts, but two sounds about right to us. But what’s also important in looking at their projections is not just each year, but what FOMC participants are looking at in the longer run. Now, the median projection for the longer-run Fed Funds Rate is only 2.9% as of its most recent update in September. Now, that’s down from 3.8% in the middle of 2015. So what does that mean for investors? It just means that the pace is going to be very slow and very gradual, and that the impact to your bond holdings might not be as bad as you may expect. Meaning the prices might not fall that drastically.

Now, given this environment, we do see some types of investments that do make sense. We think investors should actually lower or reduce their average duration or average maturity because lower duration bonds tend to be less sensitive to rising bond yields than those with higher durations. And if you’re in short-term bonds, they can tend to better take advantage of rising rates if they do come to fruition. We also like floating rate coupon investments. Their coupons are based on short-term benchmarks, so as the Fed does continue to hike rates, investors in those should start to earn higher income payments, and their prices tend to be relatively stable.

NATHAN: Now, let’s shift the discussion to next week’s presidential election. One area that may be more affected than others by the results of the election is the municipal bond market. Now, Collin, why is that?

COLLIN: Well, municipal bonds are impacted by tax rates, and each candidate has very different proposals on the future of tax rates. Trump’s proposal looks to eliminate the number of tax brackets, and it reduces the top rate down to 33%. The proposal also eliminates the Alternative Minimum Tax and the 3.8% net investment income tax that came as a result of the Affordable Care Act. So under his proposal, if tax rates were to fall, that would generally make municipal bonds less attractive because there’s less need for tax-efficient investments. Now, Clinton’s proposal calls for higher tax rates for high-income earners. Now, likewise, that would make municipal bonds more attractive because investors would be looking for investments that can help lower their tax bill.

Now, of course, tax policy is not just the job of the President. It needs to be approved by Congress. Regardless of what happens at the election, you know, we don’t know if either proposal will actually come to fruition.

NATHAN: Well, that’s all the time we have. Collin, thanks so much for your insights. If you want to read more from Collin, you can do so by going to the Fixed Income section of Schwab.com. You can also go to Twitter @SchwabResearch to find commentary from Collin and other Schwab experts. And if you have any questions, please call and talk to a Schwab financial professional. We’ll be back again. Until next time, invest wisely. Own your tomorrow. 

Important Disclosures

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. Please note that this content was created as of the specific date indicated and reflects the author’s views as of that date. It will be kept solely for historical purposes, and the author’s opinions may change, without notice, in reaction to shifting economic, business, and other conditions.

Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed. Supporting documentation for any claims or statistical information is available upon request.

Past performance is no guarantee of future results and the opinions presented cannot be viewed as an indicator of future performance.

Schwab Center for Financial Research (“SCFR”) is a division of Charles Schwab & Co., Inc.

Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed-income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors. Lower rated securities are subject to greater credit risk, default risk, and liquidity risk.

Tax-exempt bonds are not necessarily a suitable investment for all persons. Information related to a security's tax-exempt status (federal and in-state) is obtained from third-parties and Schwab does not guarantee its accuracy. Tax-exempt income may be subject to the Alternative Minimum Tax (AMT). Capital appreciation from bond funds and discounted bonds may be subject to state or local taxes. Capital gains are not exempt from federal income tax.

Schwab does not provide tax advice. Clients should consult a professional tax advisor for their tax advice needs.

While the market value of a floating rate note is relatively insensitive to changes in interest rates, the income received is highly dependent upon the level of the reference rate over the life of the investment. Total return may be less than anticipated if future interest rate expectations are not met.

The election analysis provided by Charles Schwab & Co., Inc., does not constitute and should not be interpreted as an endorsement of any candidate or political party.

Core PCE Price Index is personal consumption expenditures (PCE) prices excluding food and energy prices. The core PCE price index measures the prices paid by consumers for goods and services without the volatility caused by movements in food and energy prices to reveal underlying inflation trends.

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