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The Fed Plays It Safe, December Hike Likely

The Fed Plays It Safe, December Hike Likely

  • The Federal Reserve left its policy rate unchanged at 0.25%–0.50% at its November meeting, matching market expectations. However, the accompanying statement left the door open to a rate increase at the Dec. 13-14 meeting.
  • The statement said “the case for an increase in the federal funds rate has continued to strengthen” and  indicated the Fed's confidence in reaching its goals of full employment and 2% inflation in the “medium term.”
  • Barring any major negative surprises in the economic data, we expect a rate hike at the December meeting, which appears to be the consensus expectation.

 

The Federal Open Market Committee (FOMC) left the federal funds rate target unchanged at its November meeting, but left the door open to a rate hike at its next meeting on Dec. 13-14. The decision to leave the rate unchanged at 0.25%–0.50% matched market expectations.

The key phrase in the Fed’s statement was that the case for tightening policy “continued to strengthen” and that “inflation has increased” since the last meeting. Indeed, many measures of inflation are already above the Fed’s 2% target level, although the Fed’s preferred measure—the core deflator for personal consumption expenditures—is still below that level. 

Inflation indicators have edged up over the past year

Inflation indicators have edged up over the past year

Source: Bloomberg. Readings for each category are as of 9/30/2016 and 9/30/2015.

Although the Fed didn’t include a specific time frame for the next rate increase, it did cite improving economic data and progress toward reaching its goals of full employment and 2% inflation. That suggests to us that a rate increase at the December meeting is likely.

There were two dissenting votes at this meeting, “each of whom preferred at this meeting to raise the target range for the federal funds rate to 1/2 to 3/4 percent,” according to the statement.

Barring a major downturn in the economic outlook or a tightening in financial conditions, we agree with the market consensus view that a rate increase in December is likely. Soon after the meeting, the odds of a rate hike in December implied by the fed funds futures contract rose from 68% to 78%.

Market reaction to the announcement was muted since it was largely in line with expectations. Bond yields and the dollar declined modestly, while the stock market dipped briefly.

Steps investors might consider:

  • Investors should consider scaling back the average duration of their portfolios to reduce their interest rate risk.
  • We would be cautious about having too much exposure to lower-credit-quality bonds, such as high-yield bonds, since yields are quite low and valuations appear high relative to long-term averages.
  • We would consider underweighting developed market international bonds because the U.S. dollar is likely to rise as the Fed tightens policy, and yields in other markets are quite low, making the risk/reward outlook unattractive.

What you can do next

  • Make sure your portfolio is diversified and aligned with your risk tolerance and investment timeframe. Want to talk about your portfolio? Call a Schwab Fixed Income Specialist at 877-566-7982.
  • Watch Schwab experts discuss other market and economic topics in the Schwab Market Snapshot.
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Important Disclosures

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.

The information presented does not consider your particular investment objectives or financial situation (including taxes), and does not make personalized recommendations.

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.

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. 

International investments are subject to additional risks such as currency fluctuation, geopolitical risk and the potential for illiquid markets

The Personal Consumption Expenditures (PCE) deflator, also referred to as the PCE price index, is an indicator of the average increase in prices for all U.S. personal consumption. The less volatile measure of the PCE price index is the core PCE price index, which excludes the more volatile and seasonal food and energy prices. 

Fed fund futures are cash-settled instruments based on the average daily effective federal funds rate, as published by the New York Federal Reserve Bank, over the course of the contract delivery month.

Duration is a measure of the sensitivity of the price of a fixed-income investment to a change in interest rates, expressed as a number of years.  

(1116-P6DW)

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