Throughout the whole of 2015, markets speculated when the Federal Reserve would finally take the plunge and begin raising interest rates. After fits and starts all year, the Fed raised interest rates in December. Though they only raised interest rates by 25 basis points (0.25%), the message behind the move was far more important. In effect, the Fed signaled their belief that the US economy had enough momentum, despite the darker clouds over the international outlook, to weather its preferred path for gradual, “data driven” normalization. The Fed also laid out a plan to continue to raise interest rates by 25 bps each quarter until we reached more normal levels. After the rough start to 2016, however, the Fed last Thursday signaled a potential change in policy.
Why this change less than six weeks after the first hike took effect? Many technical factors have continued to unravel this year, including the continued decline of commodity prices, depreciation in asset prices, and weaker-than-expected corporate earnings. Moreover, the outlook for corporate earnings in 2016 has deteriorated as of late.
At this time, it is unlikely that the Fed will cut interest rates, insert another round of QE, or reverse course completely on December’s decision. However, if these technical factors do not improve, it is likely that they will not exacerbate the problem further by continuing to raise interest rates throughout the year as planned. Simply put, the Fed doesn’t want to repeat past mistakes by raising rates into a situation where it could further dampen already-tepid economic growth.
Many believed that the Fed’s announcement in December would have us back to normalized interest rates by the end of the year. History has shown that interest rate normalization takes years, not months. Bob Reiser pulled away from consensus thinking in “2016: A Year of Transition, and Adrian Cronje warned of this possibility when speaking on the Fed’s December decision: “Market participants are wanting the Fed to acknowledge that this normalization will be slow, start-stop as economic data confirms progress towards their goals, occur over a much longer period of time, and that interest rates are not likely to reach levels they have in past tightening cycles. In short, they want the Federal Reserve to be more patient in raising interest rates than in past tightening cycles.”
Despite a potential delay in hikes, we believe that the Fed is still on a path to slow and gradual normalization in line with economic growth. Please see our 2016 Capital Markets Forecast for more on our views on interest rate progress and when we believe normalized rates will appear.