Fed Policy: Slow, but Not Necessarily Steady

With a gradual approach to tightening, each Federal Reserve meeting next year could offer drama of its own.

The Federal Reserve has been messaging in the direction of a rate hike for a while, so the markets were well prepared for its decision today to increase the Fed Funds rate by 25 basis points-the first such increase in nine years.

Fed Chair Janet Yellen has been saying since the beginning of 2015 that the FOMC was getting ready to normalize rates from zero, and that when the process began, the committee would take its time. Although the communications have sometimes been unclear, ultimately these two elements of the message have been important in setting market expectations.

The December rate increase is likely not a one-off event. In our view, tightening should be a gradual process-something that is reflected in forward pricing, which late last week indicated roughly an 80% probability of a rate hike, and, looking ahead, a Fed Funds rate of about 90 basis points by the end of 2016.

Drama around the Data

There will be eight Fed meetings next year, and I believe things could get very interesting. If the markets are right (and Fed Funds futures have been far better than the Fed and Wall Street economists at predicting the trajectory of monetary policy), you could have rate increases coming out of two or three of these meetings. It's very possible that the Fed will pause at the January meeting and wait and see what happens, with any moves then or later dependent on data readings. In my view, the effect will be to build suspense around each of these meetings, as FOMC members and the markets debate the proper course of action.

Importantly, the transition that the Fed is commencing is quite normal-from an aggressive stimulus-driven to fundamentals-driven economy-and the type that has occurred in every U.S. monetary cycle of the modern era. Such transitions can be tricky from a market perspective, as investors tend to doubt the growth side of the equation. Of course, the current cycle has been far from normal, but I believe that investors have gained confidence that the U.S. economy and markets can continue to do well once the process of normalization is underway.

Influences and Opportunities for 2016

In the next year, as always, the Fed will have three focal points to its analysis: inflation, employment and financial market conditions. With the normalization of lower energy and commodity prices, many people thought the good news on inflation was behind us, yet we just had another leg down in energy prices. So this will bear watching. The same goes for slowing growth in China, given its sizable impact on the world's economies-including that of the United States. Manufacturing has been a soft spot globally, but service sectors have continued to do well. U.S. employment trends also seem generally positive, if muted.

Assuming that the Fed is not making a policy mistake here, we believe that fixed income assets on the riskier end of the spectrum should benefit from its long and gradual process, including senior floating rate loans and higher-quality high yield bonds (with care around energy names). Select emerging markets debt also looks appealing from a valuation perspective. On the equity side, the prospect of slowly increasing rates reflects better growth, and thus could be supportive of share prices. However, a key concern is the path of corporate earnings and whether current stagnation (in the U.S., reflecting energy company weakness and dollar strength, among other factors) could continue.

Overall, I believe the Fed has made an important, if telegraphed, decision to begin lifting rates off of historical lows. Even more crucial, however, is the path that will be taken from here. Although controversy may emerge around each of the Fed meetings in 2016, a gradual path to ultimately moderate rate levels appears likely.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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