Fed Hikes 25 Basis Points, Signals Gradual Path

On Dec. 16, the Federal Open Market Committee (FOMC) increased the federal funds target rate range from 0-0.25% to 0.25-0.5%, in line with market expectations and Invesco Fixed Income’s baseline scenario. The committee’s “dot projections,” each member’s estimate of the federal funds rate based on personal economic projections, were unchanged for 2016, with a slight shift down thereafter. The median projection is often compared with overall market expectations. The dots signaled a faster pace of interest rate increases than the market had expected before the meeting. The FOMC statement suggested that the Federal Reserve’s (Fed) hiking cycle will continue to be data dependent, signaling that Fed officials will continue to weigh important data reports in its decisions to raise interest rates in the future.

Rate hike, inflation and the market

Although inflation has been somewhat elusive, we believe the Fed felt reasonably confident that inflation is moving toward its 2% target over the next several years. Today’s move indicates that the Fed believes that continued labor market improvement will translate to wage pressures and higher inflation in 2016. We also forecast inflation to continue to firm in 2016, supported by a stronger labor market, services and rents. Whether the market believes the committee’s inflation forecasts will determine how shorter-term interest rates behave and what overall risk sentiment will be, in our view.

We expect the Fed’s data-dependent stance to keep bond market volatility elevated going forward, especially around significant data reports. Based on our favorable 2016 US economic outlook, we expect no more than four interest rate hikes in 2016, although global asset volatility could derail this view. Currently, the bond market appears to expect about two interest rate hikes next year; a faster pace of rate hikes could negatively affect market sentiment.

Key areas to watch are US financial (lending) conditions, the US dollar and inflation expectations. Tighter financial conditions or a stronger US dollar could translate into less tightening through the interest rate channel. Inflation expectations are important to the Fed since they often feed through to actual inflation. If inflation expectations are higher or lower relative to Fed policy, this could challenge the Fed’s credibility and create market volatility.

Risk assets: Pressure from abroad

Overall, the FOMC statement continues to paint a picture of supportive domestic conditions for risk assets. We believe potential pressure on risk assets over the coming year will continue to originate from global sources, namely commodity volatility and growth disruptions out of emerging markets, especially China. We see opportunities in the domestic-focused credit sectors in the US, which have attractive valuations currently, given our view on the economy.

Important information

A basis point is one hundredth of a percentage point.

The fed funds target rate is the rate at which banks lend balances to each other overnight.

Volatility measures the standard deviation from a mean of historical prices.

Debt securities are affected by changing interest rates and changes in their effective maturities and credit quality.

The risks of investing in securities of foreign issuers, including emerging market issuers, can include fluctuations in foreign currencies, political and economic instability, and foreign taxation issues.

The performance of an investment concentrated in issuers of a certain region or country is expected to be closely tied to conditions within that region and to be more volatile than more geographically diversified investments.

Commodities may subject an investor to greater volatility than traditional securities such as stocks and bonds and can fluctuate significantly based on weather, political, tax, and other regulatory and market developments.

The information provided is for educational purposes only and does not constitute a recommendation of the suitability of any investment strategy for a particular investor. Invesco does not provide tax advice. The tax information contained herein is general and is not exhaustive by nature. Federal and state tax laws are complex and constantly changing. Investors should always consult their own legal or tax professional for information concerning their individual situation. The opinions expressed are those of the authors, are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.

All data provided by Invesco unless otherwise noted.

Invesco Distributors, Inc. is the US distributor for Invesco Ltd.’s retail products and collective trust funds. Invesco Advisers, Inc. and other affiliated investment advisers mentioned provide investment advisory services and do not sell securities. Invesco Unit Investment Trusts are distributed by the sponsor, Invesco Capital Markets, Inc., and broker-dealers, including Invesco Distributors, Inc. PowerShares® is a registered trademark of Invesco PowerShares Capital Management LLC (Invesco PowerShares). Each entity is an indirect, wholly owned subsidiary of Invesco Ltd.

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