On December 14, 2016, the Federal Reserve finally announced that it had raised its target for short-term interest rates by a quarter-percentage-point to a range of between 0.5% and 0.75%. That marked only the second time it had increased rates since 2006, the first being in December 2015. The hike signified the Fed’s confidence in an improving American economy, with Fed chair Janet Yellen saying the economy had improved during the second half of the year and was expected to continue performing well.

The Fed had slashed rates to zero in the midst of the financial crisis of 2008, and kept it there during the Great Recession and beyond. But the U.S. economy has been showing solid signs of recovery and may no longer need the Fed’s crutches. America has added jobs for 74 consecutive months while the unemployment rate has fallen to 4.6%, its lowest level since 2006.

Uncertainty in 2017

When the Fed met in September, it projected two rate hikes in 2017. But in December, it penciled in a total of three quarter-percentage-point increases for the year signaling that benchmark rates could rise more steeply in 2017 than earlier expected. Yellen did her best to play down the change, but admitted that they were operating under a ”cloud of uncertainty,” and that a variety of factors could alter the course of economic policy.

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Meanwhile, higher equity prices, rising longer-term interest rates, and a stronger dollar signal that the market believes that the Trump administration will bring in a new era of fiscal expansion through higher spending and tax cuts across the board.

The yo-yo Fed rate-hike is not a unique situation. After raising rates by a quarter-percentage-point in December 2015, Fed officials expected four more to come in 2016, yet only one materialized late in the year. It wouldn’t be much of a surprise if we end up seeing just two hikes instead of the three projected by the Fed. In fact, the futures market is banking strongly on just two rate hikes during the year, with the first coming not earlier than June.

Markets take it in stride

As expected, a single rate hike of that magnitude did not exactly disrupt the markets, though the Dow fell 119 points immediately after the announcement. All major markets rang out 2016 with solid gains. The fact that the rally fizzled out in the final days of the year has less to do with the rate hike and more to do with pension funds reallocating money out of equities and investors making portfolio adjustments after the strong gains.

The final trading week of the year turned out to be the worst since Trump’s Nov. 4 election. The S&P 500 lost 1.1% to finish at 2,239; the Dow fell 0.8% to close at 19,770 while the Nadsaq tanked 1.5% to close at 5,383 by year-end.

The S&P 500 though still managed to finish the year with an 11% gain; the Dow Jones climbed 13.4% for the year while the tech-heavy Nasdaq finished 7.5% up.

The second-oldest bull market has entered the new year with more spring in its step than it did in 2016. All major markets have been rallying, with the S&P 500 boasting the strongest gain of 1.35% YTD (Year-to-Date).

S&P 500 Index (SPX) Year-to-Date Returns

Source: CNN Money

The Dow has racked up gains of 0.69% and flirts with 20,000 at 19,942.

Both the retail and tech sectors have started off strongly. The Consumer Discretionary Select Sector ETF (XLY) is up 1.86% YTD while the Technology Select Sector Fund (XLK) has tacked on gains of 1.41% over a similar timeframe.

The strong performance by the markets so early in the year is a complete antithesis of what happened last year. Traders were expecting a rough start to the year in 2016 due to squeezed corporate earnings and the expected multiple rate hikes. This time around stocks are rallying hard on expectations that the Trump administration will push through with the planned tax reforms and the fiscal stimulus program.

There are some risks, though, to this bullish thinking.

Risks to the bullish thesis: historical precedents

Mr. Trump will be sworn into office on Jan. 20, 2017, and that’s when the acid test begins. Until then, traders can expect the markets to continue their rally due to the strong momentum built in 2016. But once Trump becomes POTUS, the markets will start trading on his ability to deliver on his campaign pledges and the timing of the necessary legislation. If Mr. Trump can quickly push through with the promised corporate tax cuts, for example, we may see a boost to earnings, which is a big positive for the markets.

This, coupled with the fact that the big drag caused by falling oil prices has come to an end, should probably be enough to sustain the current bull market for maybe another year. A reduced regulatory backdrop will only feed into that. Most strategists expect single-digit gains by the S&P 500 in 2017 to hit a range of 2,300-2,400.

By the same token, if the necessary legislation to make these changes drags on too much, expect the markets to react negatively.

But perhaps the biggest wildcard here remains uncertainty regarding the number of rate hikes that will come in 2017. There’s a historical precedent for the Fed to follow one interest rate move with a series of other moves in quick succession. What happened in 2016 was actually an exception rather than the norm. And when rates start rising, traders and investors have historically underestimated how far and fast they would go up.

The Fed has predicted that rates will hit at least 1.25% by the end of 2017, but Trump’s plans to cut taxes and increase infrastructure spending could push rates even higher than that.

Certain investor groups lag the market

2017 may well turn out to be yet another bull market. But that does not automatically mean that traders will make handsome gains. Openfolio is a social network with more than 70,000 members who share their portfolios. According to CEO Hart Lambur, the average Openfolio investor finished the year with a gain of just 5%, badly underperforming the market by more than 7 percentage points. Mutual fund investors did not fare that well either.

Average 2016 fund and investor returns

Fund category	Average 2016 investor returns	Average 2016 total returns	Performance gap
U.S. stock funds	10.33%	11.89%	-1.55%
U.S. sector funds	5.78%	12.43%	-6.65%
Target-date funds	6.54%	7.15%	-0.60%
International stock funds	3.17%	3.51%	-0.34%

Source: CNBC

Hart says that bad timing and poor stock picking was to blame for the poor returns by investors. The good news for traders, however, is that target-date fund investors have enjoyed better-than-average returns over the past 10 years.

These findings might not be of much use to day and scalp traders, but can be of help to swing and position traders.

The defiant bond market

Traders and investors tend to allocate more of their capital to bonds when stock markets are skittish. Under ordinary circumstances, bond yields have a negative correlation with interest rates. When interest rates rise, bond prices fall and vice-versa.

But the bond market has lately been defying bearish expectations. Although bonds performed worse than stocks in 2016 (the U.S. Aggregate bond index climbed only 2.2%), it was hardly the bloodbath that many had predicted. Even the 10-year Treasury bond gained 0.3% in 2016, while long-term corporate bonds rallied more than 5%.

The new year is so far shaping up to be a good one for bonds too. iShares Core U.S. Aggregate Bond ETF(AGG) tracks the performance of the Bloomberg Barclays U.S. Aggregate Bond Index. The ETF is already up a solid 0.55% YTD.

iShares Core U.S. Aggregate Bond ETF(AGG) YTD Returns

Source: CNN Money

It’s therefore important for traders to keep their expectations for bond volatility in perspective. During the last three rate-hike cycles, investment firm Charles Schwab found the following:

The earliest part of the hike was the most volatile, including six months prior to the first hike. Short-term bonds were the least volatile.
Short-term bond funds were the only major category with positive total returns in each rate-hike cycle.
Intermediate and long-term sector bonds generally recovered over time usually due to the impact of reinvesting in higher-yielding bonds even as rates continued rising.

Bond yields when rates are rising from 0.0%

Source: Schwab.com

No two rate-hike cycles are exactly the same. Nevertheless, here are some important takeaways for bond traders:

Match your choice of bond funds to your time horizon.
Understand that downside risk has historically been manageable.

Takeaway for traders

Current indications are that 2017 is already shaping up to be another bull year with Trump’s administration expected to enact legislature that will have a positive effect on the markets and the economy in general. Whether he will stick to all his pledges and act quickly enough is, however, far from certain. There is also an air of uncertainty regarding how many rate hikes will come this year and when they will come, with less hikes bullish for the market and more hikes bearish.

Traders should bear this new fed rate in mind when aligning their portfolios for the new year.

Be sure to stay up-to-date on all things Stock Market related by checking back on our blog for the latest news and tips! The more you know, the better prepared you can be to profit in the market.

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