For only the second time in the past decade, the Federal Reserve decided to increase the federal funds rate. In their final scheduled meeting of 2016, the Federal Open Market Committee, in what was a highly anticipated and widely expected move, raised the overnight lending rate by 0.25% to the range of 0.50%-0.75%. The Fed stated that they had seen marked improvement in a number of areas in the economy. GDP for the third quarter rose to 3.2% from just 1.4% the previous quarter. Consumers became optimistic about the future, as Consumer Sentiment for October was 93.8 vs. a consensus estimate of 91.6. While this increase was an improvement, the Consumer Confidence Index, which surveys 3000 households, trounced estimates of 101.2 to post a reading of 107.1. According to ADP, Labor markets affirmed all of this positive data as the private sector created over 216,000 jobs compared to an estimated 165,000. This job growth helped bring the national unemployment rate down from 4.9% to 4.6%.
What does this mean?
While rate increases are typically used by the Fed to temper economic growth, investors should view this as a positive sign that equity markets have improved enough to handle the rate increase. The Fed has acted slowly in the timing and telegraphing of their rate hikes as the economy has rebounded from the financial crisis lows of March 2009. As you can see from the chart below, when historically aggregating all of the Fed tightening cycles, equities represented by the S&P 500 Index have performed best during slow tightening cycles.
As of today’s Fed meeting, the committee is forecasting a path of three rate increases in 2017, but that is dependent on the economic picture and related data. There are a number of other factors that could impact the outlook for rate increases and the economy, such as the policies of the incoming Trump administration.
In addition, Fed rate hikes have historically helped equities when the level of the 10-year Treasury yield was less than 5.0%. With a 10-year Treasury yield currently sitting around 2.5%, there is a lot of room to move before there is cause for concern.