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No Surprise: The U.S. Federal Reserve Raises Rates

The U.S. Federal Reserve (Fed) today increased the federal funds rate target by 0.25% to a range of 0.75% - 1.00% - a move that was widely anticipated by investors. This is the third time the Fed has increased rates since December 2015, and the Fed is now forecasting it will raise rates at least two more times in 2017, and three more times in 2018.

Why increase rates now?

The Fed has two mandates: price stability (a low and stable rate of inflation) and full employment. The Federal Open Market Committee (FOMC) considers inflation at 2% as most consistent with the Fed’s dual mandate over the long term. The latest information shows the PCE price index (prices excluding food and energy prices — the Fed’s preferred measure) at 1.7%,1 in line with the Fed’s 2% goal. The most recent jobs report indicated that the unemployment rate in the U.S. is presently at 4.7%.2 The Fed considers 5% - 5.2% as full employment.

With both mandates fulfilled, and the U.S. economy on solid footing, the Fed believes it’s time to begin to raise rates to prevent a rise in inflation.

The Fed cited a strengthening labour market and economic activity that continues to expand at a moderate pace as reasons for the rate increase. Job gains remain solid and the unemployment rate has not changed significantly in recent months.

U.S. dollar up, oil down  

The probability of a hike had already pushed the U.S. dollar up (relative to a basket of global currencies) over the last couple of weeks, which has led to a decline in the price of oil (as oil is priced in U.S. dollars).

It appears the market was bracing for a much more “hawkish” tone from the Fed as some investors feared the Fed would project a much faster pace of rate hikes over the next couple of years; however committee members’ expectations for where rates will be in the coming years changed little from its last meeting.

Despite the fact that the interest rate increase was expected, the Fed announcement pushed equity prices higher and government bond yields lower.

What does this mean for your MD portfolio?

MD portfolios are well diversified among many asset classes, and we have spread out risk to manage uncertainty around tightening monetary conditions in the U.S. Given the relative strength of the U.S. economy, we remain overweight U.S. compared to other developed markets.

If a rising U.S. dollar leads to lower oil prices, our equity pools are well positioned to protect against this decrease. We have a lower exposure to energy in our MDPIM Canadian Equity Pool, MDPIM Dividend Pool, MDPIM US Equity Pool and MDPIM Emerging Markets Equity Pool versus the benchmark index. Along with our overall underweight to energy in our equity pools, we have positioned ourselves to be less risky than those in the benchmark, so we expect to see some downside protection in our energy stocks. Our fixed-income funds and pools are positioned for a gradual, moderate increase of interest rates.

With regards to currency, we continue to favour the Japanese yen over the U.S. dollar in our international funds and pools. This positioning should benefit us if the yen rises in response to increased global risk.  However, the outlook for the U.S. dollar relative to the Canadian dollar remains positive so we are unhedged (have not taken measures to protect against a currency decline) in our U.S. portfolios.

We anticipated today’s Fed announcement and accounted for it in MD Funds and Pools. Ultimately, it should have little impact on the overall positioning or performance of your portfolios.