Interest rates: Past as prologue?

By Kevin Holme, Managing Director, Capital Markets

A look at how businesses can manage currency and interest rate risk in response to the Fed’s action.

In our December interest rate commentary, we advised that it was unwise to expect never-ending central bank support for the market. So we shouldn’t be surprised by the Federal Reserve (Fed) action today to raise the Federal funds rate – the overnight lending rate between banks – to a range of 0.75 percent to 1.00 percent. As we predicted as early as December 2015, and again this past September, the Fed has, and will, continue to proceed cautiously – measured in its response and data dependent – as it tries to normalize monetary policy after years of easing.

Given concerns about further rate hikes in 2017 and beyond, it important to consider both the economic fundamentals and the history of previous Fed activity during economic expansions. The current expansion has been very weak by historical standards (averaging about 2.0 percent annually) leading to a prolonged period of central bank support and resulting low rates. Recently, however, both sentiment indices and economic fundamentals have strengthened.

Since the November election, the various sentiment indices measuring business, investor and consumer confidence have improved. For example, the recent National Federation of Independent Business’s (NFIB) Business Optimism Index in the United States increased to the highest level since December 2004. Consumer confidence, as measured by the Conference Board, increased in February, and is at a 15-year high. But perhaps more importantly for the Fed, the economic fundamentals have now shifted to a consistently positive tone. The Institute for Supply Management (ISM) said on March 3, 2017, that its index of non-manufacturing activity rose to 57.6 – the highest level since October 2015 and accounting for 80 percent of the U.S. economy. Manufacturers also saw an increase in activity as separately reported by ISM. Together, the reports suggest the economy in early 2017 is growing faster than the average 2 percent growth of this expansionary cycle.

Furthermore, this expansion is making meaningful progress towards the Fed's full employment and 2 percent inflation goals. Last week, the government reported that U.S. employers added jobs at an above-average pace. On March 1, 2017, the government released the Fed’s preferred inflation index known as the Personal Consumption Expenditure (PCE) index. The inflation reading came in at 1.9 percent (as measured year over year). It is the highest level in more than four years.

Some History: To understand future Fed activity it is helpful to understand previous Fed rate hikes in the prior economic expansion. In the last expansion (2001-2007), as is typically the case, the Fed became increasingly vigilant as economic imbalances in labor, commodity and capital markets rapidly built up. In contrast, the slow pace of our current expansion and lack of similar imbalances, suggest that this expansion could last much longer than previous cycles. Nevertheless, as the economy gains momentum, it is logical to expect many more rate hikes in the future.

The above chart looks at Fed activity since 2000. In the last expansion, the Fed funds target got to as low as 1 percent in June 2004 before rising to a high of 5.25 percent in June 2006. Thus, it took only two years for the Fed to raise rates by 425 bps points. This expansion is obviously quite different from the previous cycle, but history is still a great reminder of what the Fed will do as the economy grows – less-severe tightening but tightening nonetheless.

Bottom Line. The stage has been set for higher rates coming from a Fed increasingly concerned with a variety of factors including asset price growth and growth in household spending. While the earliest the next move could come is probably June, the pressure for higher rates is clearly building. This past Friday’s strong growth in jobs and wages only buttresses this view.

We continue to advise clients to prepare for the unknown and preserve flexibility going into the future. While rates have started to trade higher recently, market conditions today still offer borrowers well- priced hedging tools to both control interest expense and preserve flexibility. We advise our clients to consider the many alternatives that go beyond the normal fixed rate swaps and loans. These include interest rate caps, collars and swaps that have embedded cancellation options to provide maximum flexibility, optionality and protection where the rate outlook continues to be uncertain. For further discussions on how MB can help your business navigate the rate environment going forward, contact your relationship banker or give us a call directly.