UBS: What Happened and Why?

The Federal Open Market Committee (FOMC) raised the target range for the federal funds rate by 25 basis points to 0.25–0.50%.The market widely expected the increase, so the focus was on the language and the FOMC members' projections for future rate increases. Both of these were marginally more dovish than expected.

The Fed is now using the term "gradual" to describe the likely path of monetary policy, and the distribution of the expected year-end target rate has drifted somewhat lower. Nonetheless, expectations for the long-run rate remained steady suggesting that gradual rate rises over the next few years could be replaced with faster rate hikes further down the line. The press conference was slightly less dovish, with Fed Chairperson Janet Yellen emphasizing again that even with rate rises, policy remains accommodative and that future decisions would be data dependent. The improvement in the labor market is now apparently taken as given, so the focus has switched to expected inflation.

This marks the first rate hike since June 2006, and also the first rate hike in an environment where the Fed balance sheet has expanded dramatically through quantitative easing. As a result, the Fed also had to expand special measures, such as reverse repos, to ensure that the fed funds rate will tend towards the mid-point of the target range.

Market Reaction

US interest rates moved modestly higher following the release of the Fed statement. The yield on the 2-year Treasury moved 4 basis points higher to 1.00% reaching this level for the first time since 2010. The 10-year Treasury increased 1 basis point to 2.27%, reflecting a slight flattening of the yield curve. The odds of a fed funds increase at the March meeting are currently approximately 40% based on implied fed funds futures contracts.

Implications for our Multi Asset portfolios

The Federal Reserve's announcement today that it would begin to increase rates was well-telegraphed — thus avoiding a communication error. Initial market reaction has been muted, suggesting the Fed also effectively avoided a policy error. That error avoidance is important, in that it reduces the chance of near-term market volatility spikes or outsized asset price dislocations. It's also notable that today's Fed forecasts for growth and inflation did not come down markedly from previous forecasts, contrary to lower expectations issued recently by some market participants. In part, that reflects the Fed's confidence in the US economy, and its belief that the global concerns it articulated in September (i.e. China) have lessened.

Essentially, the Fed has left the door open to assuming a more hawkish stance (quicker tightening) or dovish stance (slower tightening or more easing) should forthcoming data deviate significantly and persistently from their forecasts necessary to support its objectives of maximum employment and 2% inflation. How the Fed chooses to exercise that flexibility may lead to bouts of volatility leading up to or immediately following its FOMC meetings in 2016.

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