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Rate rise confirms strengthening economy

The bad news is that last week America's Federal Reserve once again hiked its benchmark interest rate, making financing costs for many individuals and corporations more expensive. The good news is that the rate hike — which came earlier than many had expected just a few months ago — largely confirms a broad improvement in economic growth and supports a more optimistic view that markets around the world are at least stabilising.

In the first quarter, so far, economic data has generally come in on the stronger side. Since bottoming last summer, consumer confidence soared to its highest level since 2001. Concurrently, the ISM non-manufacturing index, which measures employment progress and business activity, posted its strongest reading since late 2015. Other indicators, including the small business optimism indicator have also recently touched new high levels.

Since the start of the “Great Recession” in 2008, the Federal Reserve has taken a predominantly “dovish” stance by keeping interest rates artificially low and printing money through a programme known as quantitative easing, or QE for short. The Fed's consistent mandate since those darker days has been to keep the monetary pedal to the metal until inflation at least hits its two per cent target and employment shows meaningful signs of recovery.

Although the Fed's preferred inflation indicator, the personal consumption expenditure index, remains below the two per cent target at 1.7 per cent, the indicator's year-over-year increase is up from a low of 1.4 per cent early last year and fast approaching the goal. Meanwhile, US unemployment which peaked at approximately ten per cent in late 2009, has fallen below five per cent where it has remained for the past year, or so.

Confirming the better employment picture, the US Labour Department reported several days ago employers added jobs at an above-average pace in February due primarily to gains in construction and manufacturing. The 235,000 increase in jobs followed a 238,000 increase in January which was more than previously estimated, making it the best back-to-back rise since last July. Importantly, wages grew 2.8 per cent from the same time a year ago adding to the case for hitting the Fed's inflation target. The unemployment rate dropped to 4.7 per cent, the lowest level in ten years.

While business confidence and employment data appear to confirm an upswing in activity, overall US economic growth still remains relatively soft by other measures. Gross domestic product growth, the broadest measure of economic progress, is not suggesting an overheated economy. According to recent reports from the Commerce Department, fourth-quarter GDP growth fell to 1.9 per cent from 3.5 per cent in the third quarter and market expectations for the first quarter of 2017 are coming in around 2.1 per cent. Although an outlier, the Atlanta Fed recently reduced its real GDP growth estimate for the first quarter to just 0.9 per cent. This forecast had been as high as 3.4 per cent earlier this year.

Nevertheless, Fed leaders have been chomping at the bit to raise interest rates. Last month's relatively strong employment report on top of a 15 per cent surge in the stock market since last November gave them the opening they needed. Some economists worry that plans for government infrastructure spending and a much anticipated tax cut could become bogged down in political wrangling, but the Fed is not waiting around for results this time.

Going forward, expect the Fed to finally meet its stated targets for the year by raising rates a total of three times in 2017. The policy-making team needs to restore lost credibility after balking on their projected rate increase targets in both 2015 and 2016. Janet Yellen has less than one year left on her term as chairwoman of the Federal Reserve Board of Governors while vice-chairman Stanley Fischer's term will end in June of 2018. Both board members are widely expected to retire while two other vacant positions still need to be filled. Look for the outgoing crew to make their mark and not be seen as falling behind the curve. Barring unexpected geopolitical events spooking the markets, the direction for interest rates in the near term is gradually up.

Longer term, however, global growth and therefore future interest rate increases will likely be capped by the powerful headwinds of a worldwide ageing demographic combined with burdensome government debt levels. At the same time, a plethora of disruptive technologies will keep inflation at bay. In fixed income, we favour a “barbelled” maturity structure for successfully navigating this environment.

Bryan Dooley, CFA is a senior portfolio manager at LOM Asset Management Ltd in Bermuda. Please contact LOM at 441-292-5000 for further information

This communication is for information purposes only. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument, investment product or service. Readers should consult with their Brokers if such information and or opinions would be in their best interest when making investment decisions. LOM is licensed to conduct investment business by the Bermuda Monetary Authority

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Published March 21, 2017 at 9:00 am (Updated March 21, 2017 at 1:04 am)

Rate rise confirms strengthening economy

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