As expected, the Federal Reserve tightened monetary policy on December 16 for the first time since 2006. While it was only a measly 25 basis points (bp), it is still a regime change, in my view, and has significant longer term implications for investors.

On the policy move itself, Fed policymakers:

  • Raised the benchmark federal funds rate by 25 bp;
  • Declared the outlook for both economic activity and the labor market as balanced;
  • Said they intend to move gradually with respect to future tightenings and will remain data dependent.

All boiler plate stuff; no surprises at all, and all anticipated by the markets.

Dot Plot Disappointment

The only mild disappointment was in the dot plots, which map out the spectrum of expectations of all the members of the Federal Open Market Committee (FOMC) regarding the appropriate level of interest rates in the future. While FOMC members say they intend to be “gradual” about tightening, the dot plots show that in their minds “gradual” implies four tightenings in 2016. The market expectation was that the number of projected tightenings would be lower. It wasn’t, and that was a mild surprise for the front end of the Treasury market (shorter-maturity bonds that are more sensitive to Fed moves), which sold off a tad in response.

In my view, the biggest problem with the Fed communication is not with respect to the current tightening. Instead it is with reconciling the dot plots that indicate four tightenings in the coming year, their stated intention to be gradual, and the markets’ expectations of only two tightenings in 2016.

That is a significant gap between communication and expectations, and Fed Chair Janet Yellen did nothing in her press conference to bridge that gap. As a result, the markets are effectively data dependent because Fed policy in 2016 remains entirely data dependent.

As far as markets are concerned, I believe we will see a relief rally that probably carries us through the first few weeks of the new year. The credit cycle and the secular bull markets are still very much intact. However, despite our expectations that full-year returns for most asset classes in 2016 will be modestly positive, the volatility related to a variety of market challenges remains very much in place.

The moment the data flow strengthens, market expectations of Fed tightenings in 2016 will need to be reconciled with the dot plots. I believe that will be an unpleasant experience and we will likely experience a few of those episodes in 2016.

It will ultimately be a positive but nevertheless bumpy ride.

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