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March 15th Fed Rate Hike

By Ryan Lange, CFA, CAIA. Senior Investment Strategist, Great Western Bank Wealth Management

As expected, the Federal Reserve raised the federal funds rate on this date by 0.25% to a new range of 0.75% to 1.00% (from 0.50% to 0.75% previously). The financial markets already had this rate increase priced in with the fixed income markets pricing in a 100% probability of a rate hike over the past couple of weeks.

The key focus for investors for this Federal Reserve meeting was not whether there would be a rate hike, but to gauge what we should expect for the remainder of 2017 and beyond. At the beginning of this year, median expectations were for two 0.25% rate hikes this year but that has been shifting towards three rate hikes as economic data continued to strengthen. This is highlighted in the yield curve below that shows the yields on US Treasury bonds across various maturities, from 1 month to 30 years. The dotted yellow line shows the interest rates across the various maturities at the beginning of the year while the solid green line shows the current rate curve. Interest rates are higher across the curve, however the largest impact is on short term rates.

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The surprise coming from the meeting is the reduced expectations of future rate hikes. The statements issued by the Federal Reserve indicated that they will continue “gradually” increase interest rates. This caused intermediate term rates to fall between 7 to 12 basis points from levels before the rate announcement.

While the focus remains on the interest rate increases, the Federal Reserve has another tool at their disposal that they can use with some impact on intermediate term rates. This tool would be reducing the size of their balance sheet. Keep in mind that they have been increasing their balance sheet since the financial crisis in order to stabilize the economy and keep interest rates low. This was done with three quantitative easing (QE) programs. Since winding down the QE3 program in 2014, they continued to maintain their balance sheet at around $4.5 trillion and is primarily made up of treasury bonds and mortgage securities. As the assets that are currently held mature, they are still reinvesting those proceeds into new assets. The Federal Reserve has not discussed a plan to allow these securities to mature and not reinvest the proceeds, but that is an option at their disposal.

The chart below shows the size of the Federal Reserve’s balance sheet over the past 10 years.

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We continue to feel that there remain many headwinds that will make it difficult for interest rates to increase at a rapid pace. Fixed income assets remain an important allocation within portfolios to control volatility.

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