In an expected and nearly unanimous decision, the U.S. Federal Reserve (Fed) announced on June 14 that it was raising its Fed funds rate 25 basis points to 1.0%-1.25%. It was the third consecutive increase in the last six months, and the Fed anticipates raising rates one more time later this year.
Why did the Fed raise rates?
The Fed believes that the U.S. economy continues to grow at a moderate pace and with the labour market at full employment and inflation near its 2% target, the biggest threat to economic stability is the economy overheating and rising inflation.
Biggest news: Balance sheet normalization program
The biggest news coming out the Fed announcement today is its plan to reduce the size of its balance sheet. Following the financial crisis in 2008 and the resulting recession, the Fed had increased its balance sheet to $4.5 trillion by purchasing U.S. treasuries and mortgage-backed securities.
The expansion of its balance sheet reduced long-term interest rates, lowering the cost of borrowing to millions of American consumers and businesses and helping to stabilize the economy.
The Fed announced its plans later this year to begin a process of allowing $6 billion a month in maturing treasuries and another $4 billion a month in mortgage-backed and agency debt to not be reinvested or “roll off” its balance sheet.
This amount will be generally increased over six-month periods to a maximum of $30 billion a month in treasuries and $20 billion a month in mortgage-backed and agency debt. This will be done very cautiously to ensure the reduction in future purchase of treasuries and other securities does not negatively impact economic conditions.
How does the decision impact MD portfolios?
At MD, we believe that the U.S. economy remains strong as evidenced by this third consecutive interest rate hike. We continue to maintain an overweight position to U.S. equities relative to Canadian and international equities.
We have not implemented a currency hedge in our U.S. funds and pools (in other words, we have not taken measures to protect against a U.S. dollar decline), as the Fed anticipates it will raise interest rates at least one more time in 2017 and three more times in 2018. We believe this will be a positive for the U.S. dollar relative to the Canadian dollar.
We continue to maintain a lower exposure to the energy sector in our Canadian, dividend and U.S. portfolios due to the increased volatility of energy stocks, and see greater opportunities in other sectors of the stock market that provide better returns on capital.
While we source ideas in our funds and pools through bottom-up, fundamental stock selection, the lower exposure to energy should also benefit benchmark-relative performance in our funds and pools. We believe future increases to the Fed funds rate will cause a rise in the U.S. dollar, putting further downward pressure on the price of oil and the energy sector.
In general, we do not anticipate today’s announcement by the Federal Reserve will lead to changes in our portfolio positioning.