The Fed Raises Rates, Signals Faster Pace on Rate Hikes in 2017

As several investors had generally anticipated, the Federal Reserve Board last week raised a key short-term interest rate by 25 basis points, to 0.50%. The Fed highlighted continued strength in the U.S. economy–particularly in the labor market, where it noted that employment gains have been solid in recent months. It also cited moderately higher household spending and inflation during the past year as additional drivers behind the decision to boost rates.

The Fed’s move pushed the yield on the 10-year Treasury note to its highest level in more than two years (see the chart below). Recent interest rate increases are being fueled by perceptions that the Fed may raise Fed Funds rates at a faster, more aggressive pace in 2017 if government spending increases significantly.

CHART: 10-Year Treasury Yield Hits 2-Year High

Overseas, manufacturing activity in the European Union was stronger than anticipated (as measured by the Eurozone Manufacturing PMI), helped by the weakening euro. The PMI survey also showed a rise in inflation, which some investors believe may indicate a strengthening economy.

GAIN: Active Asset Allocation

The Fed’s decision to raise rates along with its statement about the future pace of rate hikes appeared to have caused the CBOE Volatility Index (VIX), which measures expected future stock market volatility, to rise slightly. However, at its current level of 13 the VIX remains near historic lows.

Global equity markets were mixed last week, with U.S. stocks flat and foreign indices down. The U.S. dollar rose against a broad basket of foreign currencies, putting pressure on international markets. Meanwhile, alternative asset classes continued to struggle, as they have during most of the fourth quarter. For example, gold prices fell more than 2% last week, and are down 14% since October. Likewise, real estate is down more than 5% quarter-to-date.

We continue to favor U.S. stocks over foreign shares, with an emphasis on small-company stocks. On the fixed-income side, the corporate sector remains our primary overweight position (through high-yield bonds and preferred stocks).

PROTECT: Risk Assist

Last week, the Fed signaled that it expects to raise interest rates at a slightly faster pace going forward than many investors had anticipated. That news appears to have contributed to sharply higher global interest rates and a stronger U.S. dollar. Global equities overall were down slightly for the week.

Risk Assist portfolios continue to be positioned to participate in the markets, with overweights in small-cap stocks, high-yield bonds and preferred securities. We do not anticipate that this positioning will likely change during the rest of 2016.

SPEND: Real Spend

Yields on fixed-income securities rose last week, causing bond prices to fall. The difficult week for bonds was driven in part by the Fed’s indication that it may raise rates at a slightly faster pace going forward.

Real Spend’s overweighting to equities has benefited the portfolios: While the S&P 500 is up more than 4% quarter-to-date, the Barclays US Aggregate Bond Index is down more than 4%–and long-term Treasury bonds* have plummeted by more than 14% so far this quarter.

* iShares 20+ Year Treasury Bond ETF