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More Rate Hikes Good for the Market?

- By Nicholas Kitonyi

On Dec. 14, 2016, the federal funds rate was hiked by 25 basis points to 0.75%. More hikes are expected in 2017, but early this month, Fed FOMC members decided to maintain the interest rate at 75% for the time being without ruling out further increments. The next meeting of the Fed is slated for Wednesday, March 15, and analysts believe that the current rate of 0.75% will hold.


Last week Fed chair Janet Yellen met before a congressional committee and discussed all aspects of the U.S. economy. The vice chairman of the Federal Reserve Bank, Stanley Fischer, made it clear that the U.S. economy is fast approaching full employment. This means that interest rates will rise gradually.

The Fed had set an inflation target of 2%, and the economy is steadily moving toward this objective. As of January 2017, the US inflation rate was pegged at 2.5, which is more than the rate the Fed had targeted in order to initiate a second rate hike. On Thursday, Feb. 16, Fischer made it clear that the Fed is on track for another 25-basis point rate hike, but no specifics were provided.

Fischer favors gradual and modest rate hikes

Yellen believes it would be unwise to wait an inordinate amount of time before raising rates again. The U.S. economy is burning hot, and low rates could prove devastating if left unchecked. Monetary tightening is possible via several measures including rate hikes and asset sales.

At the height of the global financial crisis, the Fed was pumping billions of dollars into the U.S. economy by purchasing assets such as bonds on a wide scale. That policy was tapered off in 2014 and the Fed is now in the process of raising interest rates to stabilize the economy.

In 2014, Fischer quelled expectations of rampant rate hikes by stating that it would be a matter of years, not weeks or months, for federal funds rate increases. However, the U.S. base interest rate has been hiked twice since Fischer's comments, and further increments are expected in 2017.

Dollar Index tempered by Fischer's comments

What many traders want to know is whether Yellen and Fischer's comments are in line with those of other FOMC members. Recently, several high-ranking officials at the Fed have adopted hawkish positions.

The reason for this is clear: the U.S. economy could overheat if the low costs of borrowing are maintained indefinitely. For most market players, the expectation of three rate hikes in 2017 still stands. Traders at Lionexo binary options have seen a flurry of call options on the dollar as the probability of a rate hike grows with every passing week. According to the U.S. Dollar Index, the greenback is marginally weaker (-0.45%) at 100.64 with a 52-week high of 103.82.

A rate hike would inject upward momentum into the Index and bring out all the dollar bulls. One of the top Fed officials, Eric Rosengren of the Boston Fed, wants to see at least three rate hikes this year, failing which he believes the economy could stumble.

The markets are looking strong in view of more rate hikes

Since the turn of the year, the stock market has showcased strength as investors maintain a bullish outlook. While there have been a few turbulent weeks, the overall direction has maintained an upward movement with most indexes hitting record highs.

The Dow hit 20,000 points while the Standard & Poor's 500 and the NASDAQ composite have continued to rise. The associated ETFs have also mirrored these gains with the SPDR S&P 500 ETF (SPY) gaining 21% over the last 12 months.

Since January, the SPDR S&P 500 ETF is up 5% and judging by the current momentum, it looks set to continue rising in the foreseeable future.

Generally, high interest rates are good for the stock market because they increase the return on capital. It is possible that the idea of three more rate hikes in 2017 resonates well with investors as they seek to maximize their returns.

Conclusion

The concept of an overheating economy is one where productive capacity cannot keep up with aggregate demand. As consumer wealth increases - owing to economic growth - inflationary pressures start growing.

Fortunately, the U.S. economy has attained an inflation rate of 2.5%, and there is still upward momentum, which should keep investors' concerns from mounting pressure on the overall economic growth.

Disclosure: I have no position in any stock mentioned in this article.

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This article first appeared on GuruFocus.