External Insight - Payden & Rygel External Insight treasury@arlingclose.com

This is an Insight written by an external organisation. The following article was written by Payden & Rygel Investment Managers and represents their views.

Analysts and commentators have been telling us all year that a fragile US economy meant the Fed wouldn’t hike at all in 2016. At several points during the year, talk of a recession and rate cuts were top of mind for some. But, for the second December in a row, the Federal Reserve elected to raise its policy rate range 25 basis points, from 0.25%-0.50% to 0.50%-0.75%. Is policy tighter now? In an objective sense, yes. However, an $18.7 trillion economy can handle a 0.25% change in an overnight rate. Indeed the most important dollar-denominated money market rates (by volume) have already moved higher and the economy steamed on.

Underpinning the decision was the consistent health of the US economy. In particular, the Fed highlighted solid job gains in recent months and increases in inflation as reasons for raising rates. Reflecting this, the monetary mandarins revised up their expectations for GDP next year (from 2.0% to 2.1%), revised down their forecast for the unemployment rate (from 4.6% to 4.5%), and now the median Fed forecast expects three rate hikes in 2017, not the two rate hikes expected as of September.

That is the Fed’s take. As we look ahead to 2017, here is a curated collection of our 5 biggest predictions for the upcoming year:

  1. “We were optimists before it was cool” – Worriers and doom & gloom merchants have repeatedly predicted the onset of another recession just about every year for the last few years. Why? Often the worry stems from the US business cycle being “long in the tooth,” now clocking in at 89 months. Since the post-war average cycle length is only 62, many think the end is nigh. We disagree. Calendars do not determine business cycles. Nor do we find evidence of a natural limit on how long an expansion can last. The Australians haven’t seen a recession for 25 years. Perhaps the US economy is just getting started? We think the current expansion has at least a few years left to run. Check back with us in 2018 or 2019. Since Trump’s election, a lot of other investors have joined us in the more optimistic camp. But we’ve been optimistic for a while—long before it was cool. Until the end of the business cycle is imminent, investors should still favour stocks and credit sectors in the fixed income market. We remain bullish. 
  2. Biggest Mistake: The Consensus is Wrong, Infrastructure Spending Will Not Boost the US Economy – Is the only thing standing between moderate US economic growth and a marked pick-up in activity an infrastructure spending spree? Unlikely. The time for massive fiscal stimulus was 2009 when the economy was in a recession, the unemployment rate was high and the output gap wide. We are at or near full employment. The supposed "Keynesian" benefits from Trump's proposed infrastructure spending are smaller than they would have been during 2009 if such benefits exist at all. Don’t believe the hype.
  3. Biggest Scare in 2017: Inflation Will Turn Sharply Higher, Sparking a “Scare” in Early 2017 – It seems like just yesterday that all we would hear about was lower inflation and the ever-present threat of deflation. Ah, the memories. How quickly things change. With oil prices hovering well above year-ago levels by Q1 2017, we expect to see an “inflation scare” spook financial markets. Questions will abound as to whether the Fed is “behind the curve.” Suddenly, negative interest rates and QE will seem to be relics of a distant past. Central bankers will field questions on how best to rein in inflation.
  4. Wages Have Further Room to Rise – A record string of 73 consecutive months of job growth? Check. The unemployment rate below its long-term average? Check. The lowest rate for the U-6 measure of the unemployment rate (the “real” unemployment rate) of the cycle? Check. The most jobs openings on record? Check. The lowest number of layoffs ever. Check. What’s not to like about the US labour market? Wages—one could argue—have been the “missing piece” of the labour market recovery. But that’s changing, and we expect 2017 to feature the best wage growth in a decade. Great for the consumer and overall economic growth prospects. Again, we are bullish.
  5. 2 or 3 Rate Hikes in 2017 – We don’t think the Fed is “behind the curve” but, based on our above views, we do look for at least two rate hikes in 2017. A year ago the Fed anticipated 4 rate hikes in 2016 and they ended up hiking just once—so take their revised “dots” with a huge grain of sea salt. In 2017, the composition of the FOMC turns more dovish—at least initially. Three of the more hawkish voices on the FOMC in 2016 (Esther George, Eric Rosengren and Loretta Mester) will rotate out as voters, being replaced by a dove in Charles Evans (Chicago Fed), a hawk in Patrick Harker (Philly Fed), a dove in Robert Kaplan (Dallas) and dove Neel Kashkari (Minneapolis). The President-elect will have the opportunity to appoint two new members to the Fed Board of Governors who would also be voters on the FOMC, but it will take time to manoeuver through a Senate Confirmation.

Written by The Payden Economics Team