Quick view: US rate hike as expected – but watch inflation

14/12/2017

The US Federal Reserve raised its benchmark interest rates by a quarter of a percentage point, to a target range of 1.25-1.50%. Darrell Watters, Head of US Fundamental Fixed Income, share his thoughts on the implications and what’s to come in 2018.


Darrell Watters, Head of US Fundamental Fixed Income
The Fed raised its target benchmark rate by 25 basis points (bp) on Wednesday. This was the central bank’s third interest rate hike in 2017 and the fifth in its post-2008 tightening cycle. The increase puts the Fed’s target rate range between 1.25% and 1.50%. The Fed lifted its forecast for gross domestic product (GDP) – citing tax reform as one of the drivers – lowered its estimate for unemployment, and left its inflation forecast unchanged. Markets generally took the well-telegraphed hike in their stride. However, Treasury yields rallied, continuing the morning’s reaction to soft inflation data, as investors expressed their comfort with the central bank’s unchanged tightening expectations for 2018.

Even with tax reform, we believe economic growth and inflation will remain tepid next year, leading us to expect just two rate hikes in 2018. While unemployment is at its lowest level in more than 15 years, significant upward pricing pressures are still lacking. Demographics, globalisation, automation, and e-commerce are all deflationary forces, as are continued efficiency gains in shale extraction. Tax reform could also be deflationary, depending on whether companies opt to apply refunds toward price cuts or capital expenditures. Moreover, wage pressures remain soft. While unexpected inflation would be a catalyst for higher rates in 2018, we anticipate the aforementioned forces will keep it in check.

In our view, the biggest risk to the rate market, as well as the US economy, is the possibility of the Fed adopting a more aggressive tightening path. Fed Chair, Janet Yellen, has previously cautioned the market that more rate increases are necessary in order to prepare for the next recession. Hiking three times or faster than the market expects in 2018 when the economy isn’t strong enough to handle it could result in policy error, an inverted Treasury curve, and dramatic disruption in the rates market.

Our base case, however, is that the lower-for-longer environment we witnessed in 2017 will persist. The nomination of Jerome Powell as the next Fed Chair portends continuity in the central bank’s measured pace to both raising interest rates and balance sheet reduction, which should be favourable for markets. Yellen indicated that the Fed is willing to resume asset purchases to maintain stability, if necessary. The market’s assurance that the ‘Fed put’ remains suggests that any monetary tightening in 2018 will put only marginal upward pressure on Treasury yields.

We anticipate a sustained flattening of the yield curve, but we don’t think this is indicative of an imminent recession. The Fed’s emphasis on normalising rates will continue to put modest upward pressure on the front end of the curve, while ultra-low and negative yields globally should continue to foster demand for US rates and keep longer-dated Treasury yields range-bound.


These are the individual managers’ views at the time of publication. The opinions expressed do not necessarily reflect the views of others at Janus Henderson.

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