Wednesday December 16

Stock markets respond favorably to the Fed’s decision to raise interest rates for the first time in nearly ten years. The S&P500 gained 1.5% to 2,073 and the Dow Jones rose 1.3% to 17,749. Janet Yellen and the FOMC rose the Fed funds rate by 25 basis points with the target range now at 25 to 50 basis points. In addition the expected trajectory of interest rates reflected in the Fed’s dot plot did not change from the September estimates. The statement once again reiterated that future hikes will be gradual. In response to this decision the equity VIX fell 14.6% to 17.9 as this decision removed a great deal of uncertainty from markets. In spite of gains for stocks oil prices continued to slide with Brent falling 3.3% to $37.19 and WTI falling 4.6% to $35.64. The two year Treasury yield gained 4 basis points rising to 1.01% which is the highest level since 2010. The ten year yield gained 3 basis points to 2.29%. The dollar index was relatively firm rising 0.1% on the day. The euro lost 0.2% against the dollar to $1.0911 and the yen fell 0.4% to Y122.16. In spite of higher interest rates gold prices rose. Today’s action by the Fed was essentially a vote of confidence in the US economy which explains the strong gains in equities today.

In today’s FOMC statement Janet Yellen indicated that future rate increases will be “gradual” and also added that inflationary conditions will be closely monitored. With higher interest rates in the US deflationary pressures build as it becomes more attractive to hold deposits and the money supply tightens. Considering existing deflationary pressures such as low commodity prices and the international landscape the outlook for a 2% inflation target faces pressure. In addition, the next course of action for the Fed’s normalization policy includes the downsizing of the balance sheet. The Fed purchased Treasury bonds as well as mortgage bonds extensively during quantitative easing and is still reinvesting coupon payments and principal. The Fed at some point will have to downsize its balance sheet. In today’s guidance Yellen suggested that the balance sheet will remain at its current size until interest rate policy is normalized. Along with the interest rate increase Yellen once again cited the moderate pace of economic activity and strengthening economic indicators.

With the initial and much talked about rate increase out of the way now attention will turn to the timing and magnitude of future increases. According to the Fed’s dot plot there will be four interest rate increases in 2016 with the first coming in March. However in order for these plans to be recognized there will have to be no deterioration in the inflation or labor market outlook. It is unlikely that investors will be as anxious about subsequent rate hikes as they were about the first since tighter monetary conditions will be priced into markets. To reflect these credit spreads have widened and the dollar has increased. The pace and magnitude of future rate increases will be tied closely with inflationary conditions, data, and outlook.

The Fed will raise interest rates in the economy through the overnight reverse repo program or RRP. The unprecedented size and scale of the balance sheet and of the liquidity the Fed pumped into the system will require different methods to raise interest rates than the Fed would use otherwise. Under the RRP, the Fed will sell Treasuries to approved dealers and agree to purchase them back the next day at a higher price. This will reflect an implicit interest rate that the banks will earn for storing money overnight at the Fed and holding Treasuries as collateral. From the perspective of the Fed this transaction is a repo and is a liability on the balance sheet. From the perspective of the banks this transaction is a reverse repo and is an asset on the balance sheet. By raising the interest rate on these transactions the Fed hopes that the market interest rates on other transactions will increase which will then have a ripple effect through all types of debt agreements.

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Wednesday December 16

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