A 0.25% increase in short-term rates is unremarkable on its face, but what we’ve seen over these past few weeks points to a new dynamic in the Fed’s relationship with the market.
First, it’s clear that the Fed is now more concerned with meeting its intended target than soothing market anxiety. Since 2008 until just recently, the Fed was extremely sensitive to the market’s response to any hint of a rate rise. The Taper Tantrum and subsequent Fed assurances epitomized this dynamic. A month ago, the markets were not even pricing in a rate hike. Unlike in past years, when the Fed forestalled repeatedly, this time the Fed stopped waiting for the markets to get comfortable. Instead, Chair Yellen repeated her intentions, the market listened, and the Fed acted.
Second, although we expect the Fed to continue making its intentions clear, markets will be harder pressed to predict the timing and magnitude of rate changes. We’re in a new world now, where the easy trade is over. In the years immediately following the Financial Crisis, bond traders could be on the right side of the trade with very little effort. Back then, Chair Bernanke was explicit that rates would not move for a certain period. When the Fed shifted from a calendar-dependent approach to a data-dependent one, things got a little harder for bond traders, but not much. That’s because the data thresholds that the Fed put forth were far from attainable at that time.
Now, the economic picture is less clear cut. While we certainly don’t see a recession this year, GDP growth is nothing to get excited about. Some of the Fed’s thresholds—most notably, U.S. employment—support a return to more normal rates. Yet, softer-than-expected GDP growth, slowing credit growth and less-than-robust capital expenditures are among the indicators that point to a more cautious economic outlook. Also, much of the recent optimism has been driven by post-election anticipation of tax, fiscal and regulatory policy changes, but as we noted in our outlook, turning promises into policies will take time.
What can we expect from here? Short-term rates are unlikely to soar because the economic data has a ways to go. I believe that rates will settle in at 1.75% to 2.00% over the next four to five quarters, with two more rate hikes this year, possibly three. Here’s why: Earlier this month, Chair Yellen spoke here in Chicago. She made clear, as she has in the past, that the Fed intends to target a real (inflation adjusted), neutral (neither too hot nor too cold) federal funds rate. Long-term, that rate should be around 1%. In other words, if inflation were 2%, the fed funds rate would hover around 3%. Chair Yellen went on to say, however, that today’s unusual conditions—the result of global debt levels, balance sheet recessions, aging demographics, among other factors—are leading the Fed to shoot for a real neutral fed funds rate of closer to 0%. So, given our expectation of inflation in the 2.0% -2.5% range and a dovishingly leaning Fed, that leads us to our expected 1.75% to 2.00% range over the next year or so.
Long-term rates will be more contained than many believe. Conventional wisdom holds that short-term and long-term rates rise in tandem, but that’s just not the case. Parallel rate rises have been extremely rare. Right now, the market is expecting 10-year rates to be around 3% or less for the next couple of years. To me, that sounds about right. As I noted, the U.S. economy is not on the cusp of a breakout, and other global central banks are likely to remain highly accommodative.
We see plenty of opportunities in the bond market for active investors. There’s going to be a lot of noise as this new dynamic between the market and the Fed takes hold. The noise is good for an active, experienced investor who can still find ample incremental opportunities in a market with more opinions (less consensus). Less precise guidance from the Fed requires investors to do more of their homework-and that’s fine by us.