Economic Review 4Q 2016
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.
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.
Non-farm 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.
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.
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.