Fed Hints at December Rate Hike

During her congressional testimony on Nov. 4, Federal Reserve Chairperson Janet Yellen suggested a December rate hike is likely following the release of a strong jobs report earlier in the week. Noting that recent economic strength brings the threat of inflation back into the equation, Yellen qualified her remarks by stipulating that an employment-based rate hike would make sense “if the incoming information supports that expectation” between now and then.

It looks like the bond market isn’t waiting around for confirmation, as the yield on the two-year Treasury note immediately surged to its highest level since 2011. However, in absolute terms that still leaves its yield less than 1%, well below its long-term historical average. Over the past 35 years the average yield on the two-year note is a whopping 5.75%, but that figure is skewed by the high interest rates of the 1980s.

Although the Fed does not have an official policy of targeting yields on Treasury securities, it keeps a close eye on the yield curve as the U.S. economy enters and exits inflection points throughout an economic cycle. My guess is they are okay with the two-year note anywhere below 1% in the current environment, and below 3% for the ten-year note. The thirty-year bond is less problematic since it acts as more of a lagging indicator and is not normally used by lenders to set borrowing rates.

Those rates may sound high to anyone on the paying end of an adjustable rate loan who has become accustomed to an artificially low “ZIRP,” or zero interest rate policy, for the past few years as the global economy deleveraged to recover from the “Great Recession.” But now that the jobs and housing markets have improved to the point that they appear capable of standing on their own two feet, the Fed is prepared to begin the process of gradually shortening the crutches that have been supporting them.

The stock market’s immediate response to Yellen’s comments was fairly muted, as a small rate hike was already baked into interest rate assumptions for 2016. In fact, most highly leveraged securities such as REITs experienced a substantial decline in the first half of this year once it became apparent the Fed would most likely abandon its ZIRP in 2015. And virtually every energy MLP had already seen a steep drop in value during the past year due to plummeting oil prices that ravaged the entire energy sector, so a tiny uptick in borrowing costs is the least of their worries.

In terms of GDP, it’s unlikely that an incremental rise in short term rates will hurt the credit-dependent housing and automobile industries, since wage growth is expected to grow by a comparable amount now that the unemployment rate has declined to 5.1%. If that does not happen, then the Fed would be wise to withhold further hikes until wages catch up. But if wage growth gathers steam in 2016, then we’ll probably see a series of quarterly rate increases of comparable magnitude.

Implementing the first rate hike in the month of December is a canny move, as the stock market will be distracted by several other elements that are just as significant in the short term. Mutual fund managers will be going through their annual rite of “window dressing” to rid their portfolios of unwanted losers, while institutional money managers will already be focusing on year-end earnings reports to prepare for 2016. By the time the rest of us get back to our desks in January, we may not have noticed the rate hike at all.

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