Trump and the Fed - will rates head higher?
Sadiq S. Adatia
Opinions as of December 16, 2016
The world was on the edge of financial collapse eight years ago when the U.S. Federal Reserve slashed interest rates to almost zero. It’s been a long road back. But with the U.S. unemployment rate now sitting at a pre-crisis 4.6%, Fed Chair Janet Yellen signalled on Dec. 14 that the U.S. economy appeared to be on a solid footing and raised the Fed’s overnight rate a quarter of a percent to 0.50%.
The Fed said in a statement that inflation expectations have grown “considerably,” and will track closer to its 2% target, with unemployment dropping slightly. As a result, in a rare, unanimous decision, Fed governors indicated that they expect to raise interest rates three times by a quarter-point in 2017. “Economic growth has picked up since the middle of the year," said Yellen, "We expect the economy will continue to perform well.”
The Fed has not raised interest rates since Dec. 17, 2015 when it nudged the key lending rate up to 0.25%. Since then, the Fed has made it clear it intended to raise interest rates slowly over time. And given the low unemployment rate and continuing strength of the U.S. economy, we believe we could see the Fed rate in the 1.00% to 1.25% range by the end of 2017. But as always, that assumption depends on whether economic conditions in the U.S. and around the world continue to improve.
THE IMPACT OF RISING INTEREST RATES
If the bond market starts to price in future interest rate hikes we could see increased volatility on both sides of the border as yields move up, causing bond prices to fall – something we have already witnessed over the last month or so.
With equities, all three major U.S. indexes have hit record highs in recent weeks. But if stronger economic growth does ultimately open the door to a series of rate hikes, it could trigger increased market volatility as money shifts out of equities. In particular, the S&P 500, which includes a large number of U.S. multinationals, could be vulnerable if rising interest rates drive up the value of the U.S. dollar and erode profits on foreign earnings.
While we wait to see what transpires in the bond and equity markets, the increase in the Fed rate will almost immediately cause the cost of borrowing to rise, including on mortgages. But at this point we don’t expect it will hurt the U.S. housing sector, given the lack of supply and with U.S. household wealth sitting near a record US$89.1 trillion.1
TRUMP'S AGENDA AND INTEREST RATES
Before the polls closed during the U.S. election, stock futures were flashing red when it appeared Trump would win. But a conciliatory acceptance speech by the President-elect in the early morning hours turned the futures index around and the market rallied. At the same time, the bond market turned volatile as it priced in an interest rate increase in the belief that Trump’s plan to stimulate the U.S. economy would move ahead.
In addition to softening his stance on election night, Trump, like many politicians before him, also dropped the combative tone, and placed more emphasis on an agenda that appeals to a broader audience. So it did not surprise us that in the month since his election, the focus on immigration, terrorism and ripping up trade agreements has been downplayed. Instead, he is now concentrating on boosting the economy and reducing taxes.
The key to his plan to increase economic growth is his promised $1-trillion infrastructure-building plan,2 combined with deep, across-the-board tax cuts, including reducing corporate taxes from 35% to 15%.3 If these initiatives do come to pass, Trump’s economic team believes it could push growth into the 3% to 4% 4 annual range. We believe we could see stocks and the U.S. economy perform well over the next six months, and in the process expect that new winners and losers (chart below) will emerge across sectors of the economy.
If the economy performs well, rising corporate profits could partially offset the dampening effect rising interest rates might have on equities. Perhaps we had a glimpse of what is to come when Yellen testified before Congress in on November 17, saying that with the U.S. economy operating at near full employment, Trump’s plan could cause it to overheat and trigger inflation – leaving the Fed with little choice but to raise rates.
Still, it’s impossible to know at this point how Trump’s economic agenda will actually roll out. On one front, the fiscal hawks in the Republican party could object to elements of Trump’s plan that add to the U.S. deficit, and they could attempt to rein in his $1-trillion infrastructure plan. But with Republicans in control of the White House and both houses of Congress, the bulk of Trump’s economic agenda has a better chance of being fulfilled.
FED RATE INCREASE BACKS INTO CANADA
The Fed’s decision to raise interest rates will likely increase some borrowing costs in this country, particularly on fixed mortgages. This is because the performance of 5- and 10-year Canadian bonds are closely correlated to their U.S. counterparts, which could trend higher in a rising interest rate environment. It may also increase the cost of carrying consumer debt, which is at record levels in Canada. And this could mean that consumer spending will slow in coming years.
If this does happen, the Bank of Canada, which held its benchmark interest rate at 0.5% at its final meeting of the year on Dec. 7, may consider cutting rates in 2017. If the BoC does cut, it could help prevent a hard landing in the Canadian housing market. On the plus side, Canada’s export sector could get a bit of a lift, with rising interest rates in the U.S. combined with lower rate at home, further strengthening the greenback against the Canadian dollar. On the whole we are neutral on the Canadian economy in the Sun Life Granite Managed Portfolios and will be watching for the impact stronger U.S. growth and rising interest rates could have here.
This commentary contains information in summary form, for your convenience, published by Sun Life Global Investments (Canada) Inc. Although this commentary has been prepared from sources believed to be reliable, Sun Life Global Investments (Canada) Inc. cannot guarantee its accuracy or completeness and is intended to provide you with general information and should not be construed as providing specific individual financial, investment, tax, or legal advice. The views expressed are those of the author and not necessarily the opinions of Sun Life Global Investments (Canada) Inc. and/or its affiliates. Please note, any future or forward looking statements contained in this commentary are speculative in nature and cannot be relied upon. There is no guarantee that these events will occur or in the manner speculated. Please speak with your professional advisors before acting on any information contained in this commentary.
© Sun Life Global Investments (Canada) Inc., 2016. Sun Life Global Investments (Canada) Inc. is a member of the Sun Life Financial group of companies
1U.S. Federal Reserve
2Wall Street Journal, Nov.30, 2016