As expected, the Federal Reserve announced the commencement of its balance sheet runoff at last week’s meeting. The meeting did, however, contain a few surprises. First, the Fed maintained its expectation of another rate hike in December. Prior to the meeting, the odds of a rate hike in December were 53 percent, according to Bloomberg’s world interest rate probability, as investors weighed the Fed’s previously stated intention of a hike in December against persistently low inflation readings. Following the meeting, however, those odds spiked to 64 percent.

The Fed also upgraded its forecast of economic growth for the full year from 2.2 percent at its June meeting to 2.4 percent, implying a rather healthy 2.7 percent pace of growth in the second half. And despite maintaining its outlook for another rate hike in December, the Fed lowered its full-year core inflation forecast from 1.7 percent in June to 1.5 percent. In the post meeting press conference, Chair Yellen reiterated her view that some of the recent downward pressure on inflation was attributable to transitory influences and was likely to eventually move higher.

In addition, the Fed kept in place its expectation for three additional quarter-point rate hikes next year, but reduced its outlook for 2019 to include just two more hikes, not three. This came despite the Fed slightly upgrading its forecast for growth in 2019 and leaving its inflation outlook unchanged. The longer-run rate forecast for the fed funds rate was also reduced from 3.0 percent to 2.8 percent.

The market response to the increased odds of a December rate hike was swift. Bond yields rose across the yield curve. Following the Fed’s decision, the ten-year treasury note jumped four basis points to 2.28 percent, and the two-year made a similar move to 1.44 percent. This change comes on top of a move higher that began two weeks ago when the ten-year yield was 2.04 percent and the two-year was 1.27. The dollar also firmed on the Fed decision, and gold moved lower, continuing their own two week trends. Stocks moved slightly lower after the Fed, and ended the week with a modest loss. The S&P 500 fell just 0.1 percent. But last week’s better performers were the same as in the prior week. Financial stocks rose 2.3 percent on the week and are higher by 6.4 percent in the past two weeks. Industrials and materials both climbed 2.0 percent, adding to their recent gains (as measured by the S&P 500).

Populism Hasn’t Completely Faded Overseas; Markets Brace for Tax Reform

In Germany, Angela Merkel’s CDU party was victorious in national elections on Sunday, but with a vote total that will necessitate the formation of a ruling coalition that may prove difficult to construct. The main right-leaning opposition party received enough votes to gain a say in parliament, providing evidence that the voice of populism has not completely faded away as suggested by some earlier elections in the region. The market reaction is rather muted so far. The euro is slightly weaker, while stocks in Germany are fractionally higher and bond yields are lower in Monday trading.

On the policy front back home, the Trump administration is expected to outline its tax reform package in greater detail this week. And while any proposal will face protracted negotiations with Congress, the outline should provide more clarity on the direction of the plan, including proposed brackets for both individuals and corporations, as well as suggested changes to existing deductions. The latest effort to repeal Obamacare remains alive in the Senate, but the chances for passage appear to be slim.

Third Quarter Ends as Markets Wait for More Economic Data

The third quarter wraps up this week and the economic calendar is quite full. Among the most impactful reports, especially for the Federal Reserve, will be Friday’s Personal Consumption Expenditure (PCE) deflator reading for August. The twelve-month headline rate is expected to rise 0.1 to 1.5 percent, and the core rate is expected to remain at 1.4 percent, according to Factset. Any divergence from these expectations will have a direct bearing on expectations for a December rate hike, as will the latest reading on consumer expectations for inflation contained in Friday’s University of Michigan consumer sentiment report.

Friday also brings the August report on consumer income and spending. New and pending home sales are expected to rebound from July’s levels, as are durable goods orders. And the final tally of second quarter growth is expected to be revised fractionally higher from the previous 3.0 percent estimate. Also, investors will be keeping an eye on domestic crude oil, as West Texas Intermediate flirts with a move above its 200-day moving average for the first time since April.

Important Disclosures:
The views expressed are as of the date given, may change as market or other conditions change, and may differ from views expressed by other Ameriprise Financial associates or affiliates. Actual investments or investment decisions made by Ameriprise Financial and its affiliates, whether for its own account or on behalf of clients, will not necessarily reflect the views expressed. This information is not intended to provide investment advice and does not account for individual investor circumstances.

The S&P 500 is an index containing the stocks of 500 large-cap corporations, most of which are American. The index is the most notable of the many indices owned and maintained by Standard & Poor's, a division of McGraw-Hill.
Morgan Stanley Capital International Europe Index (MSCI Europe) is a market capitalization-weighted benchmark index made up of equities from 15 European countries, with France, Germany, and the United Kingdom representing about two-thirds of the index.

The personal consumption expenditure (PCE) measure is the component statistic for consumption in gross domestic product (GDP) collected by the United States Bureau of Economic Analysis (BEA).

West Texas Intermediate (WTI) is a grade of crude oil commonly used as a benchmark for oil prices. WTI is a light grade with low density and sulfur content.
Indexes are unmanaged and are not available for direct investment.
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