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Captain Obvious, FactSet Experts Forecast Effects of 2017’s Second Fed Rate Hike

Market Summaries

By FactSet Insight  |  June 20, 2017

Three months after the Federal Open Market Committee (FOMC) announced it would raise the target range of the federal funds rate by 25 basis points to 0.75-1.0%, Federal Reserve chair Janet Yellen announced on June 15 that the Reserve intends to raise rates again. The new range will be 1-1.25%, and the increase will occur despite dipping inflation levels.

While this change is not unprecedented, it has implications for a number of financial areas. Read on to see what Captain Obvious and our Insight contributors see as likely to be the effects of these changes in the areas of earnings, economics, M&A, and fixed income. 

U.S. Economy

Sara B. Potter, CFA, CBE, VP, Market Analysis

Once again, the FOMC lived up to market expectations in instituting a 25bp rate hike last week. While markets had already factored in this increase, there is increased uncertainty looking ahead to future rate changes. According to the CME’s FedWatch Tool, odds of another hike at July’s FOMC meeting are just 2.5%. The probability is higher for September and November (18-20%), but futures prices are now predicting that the next rate increase will likely not happen until December or later.

Behind its decision, the Fed presented a rosy economic forecast. The median GDP growth forecast for 2017 rose from 2.1% to 2.2%, the unemployment forecast fell from 4.5% to 4.3% and they lowered their inflation forecasts for this year, as well. This last data point is giving markets pause. The monthly CPI and PPI indicators for May were essentially flat and have been weak over the last few months. Continued subdued price inflation may reduce the need for further rate hikes.

However, the FOMC still wants to work toward a “normalization” of monetary policy. Raising interest rates is just one piece of the equation; analysts are closely watching for the reduction of the Federal Reserve’s balance sheet. Although FOMC Chair Janet Yellen provided no specific timing in her remarks yesterday, the process of unwinding the $4.5 trillion portfolio of Treasuries, mortgage-backed securities, and government agency debt could begin as early as September.

Earnings

John Butters, VP, Senior Earnings Analyst

The S&P 500 Financials sector was a focus sector for the market this past week, as the Federal Reserve Board increased the target range for the federal funds rate on Wednesday. Earnings for banks and other companies in the Financials sector are particularly sensitive to higher interest rates. Given this rate increase marked the third rate hike in the past six months, have analysts been increasing their EPS estimates for 2017 for banks and other companies in the S&P 500 Financials sector over this time frame?

The answer is yes. In terms of EPS estimate revisions, 38 of the 65 companies (58%) in the S&P 500 Financials sector have seen an increase in their mean EPS estimate for 2017 since December 31. Three of the four sub-industries in the Financials sector with the largest percentages of companies that have recorded an increase in their mean EPS estimate for 2017 (since December 31) are bank-related sub-industries: Investment Banking & Brokerage, Diversified Banks, and Regional Banks.

Read the rest of John's analysis here.

Mergers and Acquisitions

Bryan Adams, CFA, Director, Transactions

By my count, since 1996 the Fed has changed rates 55 times: 27 decreases and, now, 28 increases with the most recent announcement (and held rates many more times over). Over the course of those 20 years, what we find in comparing the M&A activity 90 days prior and 90 days after a rate change is that the activity moves in line with the rate change. When rates are lowered, deals tend to decrease as well. Conversely, when rates are raised, activity increases. You can see this in the chart below.

Of course, that is an aggregate view, so it's worth looking at conditions as they are now. There is confidence in the broader economy, and the Fed has decided to raise rates in line with that confidence, but since July 2016, the change from the latest 12 months in M&A volume and value have both been negative—and stayed there. Confidence in the deal economy is not in line with the broader economy. Certainly there are some big deals that get done, but in general the appetite for deals is not there, and it is unlikely that a rate change is going to impact the current trajectory despite what the aggregate view shows.

Fixed Income

Patrick Reilly, CFA Vice President, Fixed Income Analytics, EMEA

The Fed continued the slow and steady drumbeat of normalization to the surprise of (basically) no one, with a move priced in and little disruption felt across markets. How the Fed can continue to finesse markets with the blunt tools of monetary policy in the face of political upheaval inside the beltway is the real story. The transparency seen in the plan to start unwinding a $4.5 trillion balance sheet via measured runoffs is a projection of stability and leadership when much of the developed world is caught in a storm of uncertainty.

While a weakening inflation picture seems indicative of greater risk to the downside (stagflation, anyone?), rate normalization will continue to improve large financial institution’s fundamentals and create a much needed cushion in monetary policy. In sticking with the “wait and see” approach, I expect the Fed to remain on hold until the fall, barring unforeseen events. Now if only we could see some movement in fiscal policy….


Everything Else (Given the accumulated years of experience having not died earlier)

Bill McCoy, Vice President, Senior Product Manager, Fixed Income Research (AKA, Captain Obvious)

Captain Obvious makes a brief appearance from his oh-so-important duties to remind his loyal minions of Fed-related obvious-isms conveyed through a convoluted maze of analogies based on the actions and words of several noteworthy experts. This line of thought was triggered in part by the famous quip, “The job of Fed is taking away the punchbowl once the party gets started.” 

  1. William Chesney Martin was a legendary Fed Chairman and the source of this quote. But in Captain Obvious’ opinion, the only problem with this simile is that it’s not really a single act. There is no single Fed hike. The more accurate mental image is of the party guest who ladles the punch into their own cup faster than the other guests (or something like that. The other analogies were worse.)

  2. Former U.S Secretary of Defense Donald Rumsfeld famously said, “there are known knowns; there are things we know we know. We also know there are known unknowns; that is to say we know there are some things we do not know. But there are also unknown unknowns.”
    In this case, the real question is when do they stop raising rates? That’s a known unknown, or a double-reverse semi-known, or something like that.  It’s unknown because even the Fed doesn’t know. Therefore the obvious (and useless) answer to the question is, “When the recession comes.”
  1. On that point what would former Lehman Brothers Chief Global Strategist, Allen Sinai think? Yes, there is a recession coming. Every recession since WWII has begun with a credit crunch, which is a shorthand way of saying the punchbowl is missing.

  2. What about former Federal Reserve chair Alan Greenspan? Pre-2008, he would have likely said that the typical recession is getting shorter and less severe, and doesn’t always lead to a financial crisis. Just because the punchbowl is missing doesn’t mean the economy is in the toilet bowl (Hence Greenspan and not Bernanke).

  3. But most importantly, what does the Captain himself think?....Puh-leze.

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