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As expected, the Federal Reserve raised interest rates last month for the first time in a decade while signaling that the pace of subsequent increases will be gradual. The Federal Open Market Committee (FOMC) unanimously voted to set the new target range for the federal funds rate at 0.25 percent to 0.50 percent, up from zero to 0.25 percent. Policymakers separately forecast an appropriate rate of 1.375 percent at the end of 2016, implying four quarter-point increases this year.
“The committee judges that there has been considerable improvement in labor market conditions this year, and it is reasonably confident that inflation will rise, over the medium term, to its 2 percent objective,” the FOMC said following a two-day meeting. The Fed said it raised rates “given the economic outlook, and recognizing the time it takes for policy actions to affect future economic outcomes.”
“The committee expects that economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate,” the FOMC said. “The actual path of the federal funds rate will depend on the economic outlook as informed by incoming data.” The group said it expects to maintain the size of its balance sheet “until normalization of the level of the federal funds rate is well under way.”
As of this writing, the market was pricing in a 53 percent probability of a March 2016 rate hike, similar to one month ago. There is virtually no chance of a move at the Jan. 27 meeting. According to a Bloomberg survey of economists, the FOMC will raise rates once in the first quarter of 2016, while bringing overnight borrowing costs to 1.13 percent by the end of 2016.
Ironically, U.S. government bonds have firmed up since the meeting. The yield on the benchmark 10-year Treasury note recently traded at 2.15 percent, compared with 2.29 percent as the meeting wrapped up. Based on trading in futures markets, the yield will rise to 2.50 percent by the end of 2016 and 2.63 percent by December of 2017.
No Need To Panic
The news media are reporting that borrowing rates of all kinds, including credit cards, auto loans and home mortgages, will soon become much more expensive. If history is any guide, however, borrowers may have little reason to panic. Each time the Fed has hiked rates over the past 40 years, longer-term securities actually outperformed short-term debt as higher rates stemmed inflation and kept economic growth from overheating, according to data compiled by Bloomberg.
Back in 2001, for example, the Fed lowered the benchmark rate following the NASDAQ crash, eventually reaching 1 percent. Then in 2004, it began raising it by a quarter percent. At the time of the first increase, the 30-year mortgage rate was 6.3 percent. During the next four months, it dropped to 5.7 percent.
As the Fed continued to tighten, mortgage rates drifted lower, falling to 5.5 percent in June 2005. By the time of its last increase in the summer 2006, the 30-year fixed-rate mortgage was at 6.6 percent. The mortgage rate only increased about one-quarter percent during the Fed’s entire tightening campaign even though overnight borrowing costs climbed 400 basis points.
With subdued inflation, a mixed global outlook and sub-par domestic economic expansion, there aren’t many reasons for the Fed to move aggressively. That supports surveys which tend to show that investors are bullish on Treasuries, despite the Fed’s actions on the short-end.
Market observers believe that uncertainty in the global economy will continue to put downward pressure on long-term rates. Fannie Mae, for example, is predicting the 30-year fixed mortgage rate will be around 4.1 percent at the end of 2016, little changed from today.
The Mortgage Bankers Association is forecasting an increase in both new and existing home sales next year. Total existing home sales are seen running at a 5.6 million annual pace by the fourth quarter of 2016, up from 5.4 million currently. New home sales are expected to jump about 20 percent to 623,000. This activity bodes well for new housing starts, which are approaching an eight-year high.
The multifamily market is likely to continue its hot streak as well. Freddie Mac said recently that favorable demographic trends will support strong multifamily growth for at least the next several years.
If the prognostications are accurate, then real estate lenders should find plenty of opportunity, in both residential and commercial markets. On the investment front, financial institutions sitting on cash may want to add some assets right away, rather than waiting for rates to rise further. The incremental returns from investing may well offset potential market value adjustments. Putting money out on the curve should provide higher levels of income in the coming year, a primary goal for most bankers.
Robert B. Segal is president of Atlantic Capital Strategies Inc., an investment advisor located in Bedford. He can be reached at bob@atlanticcapitalstrategies.com.
