As Federal Reserve Chariman Jerome Powell left the podium to close the Federal Open Market Committee’s September meeting, the governing body’s position could be summarized by his words: “…my colleagues and I are doing all we can to keep the economy strong, healthy, and moving forward.” So far, so good. With promising economic news as its guide, the Fed raised its benchmark interest rate by 0.25 percent, moving the target from 2 to 2.25 percent. Now, the attention turns to what this means for the economy and markets moving forward.
1. We all see what the Fed sees
The economic data tells the story: the recovery is good and lasting. Yet, it’s re-affirmation to see the NFIB Small Business Optimism Index rise to 108.8, its highest mark in the history of the survey dating back to 1973. Consumers are employed, making more money as told by August’s 2.9 percent year-to-year hourly wage growth, and generally happy about the economy.
Two key metrics make it easy to see why. Gross domestic product (GDP) increased at an annualized rate of 4.2 percent last quarter, and unemployment continues to sit below four percent. The Fed adjusted the projected change in real GDP higher to 3.1 percent annually in 2018, compared to 2.8 percent at its June meeting. It also projected that unemployment would decline to 3.5 percent in 2019 and 2020. Speaking of the present, while letting those rosy projections speak for themselves, Powell said, “It’s a pretty particularly bright moment … if you look back over the last decade, this is a pretty good moment for the U.S economy.” And to the Fed, that bright moment is a strong indicator that slow-but-steady rate hikes are working.
2. Continuing to assess the economic conditions on the ground
When asked about the direction of interest rate policy if and when growth slows, Powell noted, “I think we’re always going to be adjusting monetary policy to – in light of conditions on the ground.” That may mean an end to interest rate normalization in the future, although the key is deciphering how quickly that future comes. Below is the Fed’s latest dot plot chart – the committee participants’ assessments of an appropriate midpoint of target range for the fed funds interest rate. Powell himself noted that he doesn’t have a crystal ball to see the future – one that may include higher wage inflation from a tighter labor market or price inflation from recent tariffs.
3. What the moment means for markets?
Outside of an economic calamity, we believe the Fed will raise the benchmark rate again in December. And if it follows a similar path, the Fed seems to indicate the possibility of three more hikes in 2019 and another in 2020. What will this mean for fixed-income portfolios?
Corporate bonds have faced headwinds since the 10-year Treasury started moving higher, while floating-rate senior loans have performed well. The reason is simple: floating-rate loans have a lower durationthan traditional bonds, minimizing their interest rate risk. These loans can reset their coupon quickly to reflect new market rates, while fixed coupons immediately lose value once a higher market rate comes online. With conditions likely to remain the same for the foreseeable future, investors must reassess their fixed-income portfolios.