Fed signals additional tightening to come

21/09/2017

Darrell Watters, Head of US Fundamental Fixed Income and fixed income portfolio manager, comments on the US Federal Reserve’s latest policy announcement and shares his views on future rate rises.

This article was first published on 20 September 2017.
 
The US Federal Reserve (Fed) shared details of its balance sheet contraction on Wednesday, indicating the process would start in October. The central bank left the federal funds target range unchanged at 1.0% to 1.25% but indicated that the ongoing strength of the economy warrants additional rate rises.
 
Is the party over?
 
The Fed has acted as a backstop for the economy since 2008, growing its portfolio of Treasuries and mortgage-backed securities to approximately $4.5tn. We believe plans to shrink the Fed’s balance sheet have been well telegraphed and are likely to have minimal market impact. Proceeds will be reinvested as they exceed a set of rising caps, starting at $6 billion for Treasuries and $4 billion for mortgages. This approach suggests that tapering will occur at a glacial pace.
 
Furthermore, if the economy starts to sour, the Fed can step back in and underpin markets. By mid-October, however, the Fed’s board of governors will have four empty seats, and Janet Yellen’s term as Fed Chair expires in January. Market participants should be wary of a changing of the guard. A new board composition could accelerate changes in policy and have unintended effects on markets.
 
Markets may be underestimating the Fed
 
Prior to Wednesday’s commentary, market participants put the chance of another 2017 interest rate hike at just over 50%, according to Fed Fund Futures. Approximately two increases were priced in through 2019. The Federal Open Market Committee’s dot plot survey suggests that the Fed could tighten approximately seven more times in the same period. While we believe that the lack of inflation will sustain a ‘lower-for-longer’ interest rate environment, we are concerned that the market has gone too far in underestimating the Fed’s notion to raise interest rates, particularly if inflationary pressures intensify.
 
The Fed will hike as gross domestic product (GDP) growth and inflation allow, in order to create a cushion in the event the economy rolls over. The tightening cycle will remain gradual to protect the consumer – the largest engine of the economy – but we expect the number of forthcoming rate increases to fall between the market and the Fed’s expectations.
 
August data showed inflation is progressing toward the Fed’s goal of 2%. One or two more strong inflation prints will set the stage for an additional rate hike in the coming months, most likely in December or early 2018. Modestly higher gas prices, along with recovering crude oil prices, continued improvement in the labour picture and a weaker dollar are all tailwinds for a higher Fed Fund rate. While the inflation pickup is unlikely to be sustainable, these factors could jolt the bond market.
 
In the months ahead, we anticipate Treasury yields will be generally range bound, but will bump up against the higher end of that range. In our view the 5-year note faces the most risk due to its close ties to Fed policy, while the yield on the 10-year note could reach 2.5%.
 

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