The Fed Hikes: Building a War Chest

 In Market and Investment Insights

Head of U.S. Fundamental Fixed Income Darrell Watters and Portfolio Manager Mayur Saigal react to the Fed’s most recent rate hike and discuss what’s to come.

Key Takeaways

  • On Wednesday, the Fed raised its benchmark rate by 25 basis points and pointed to the healthy economy as justification for the hike.
  • We anticipate a higher but flatter Treasury curve as the Fed continues its measured pace of monetary policy normalization.
  • With inflation contained, we expect the central bank to retreat in the event of a material downturn in risk markets or a significant backup in the cost of capital.

As of Wednesday, the Federal Reserve (Fed) has three interest rate hikes under its belt in 2018, putting the federal funds target rate range at 2% to 2.25%. The Fed has raised rates eight times during this tightening cycle, with the ninth hike slated to happen before year-end, according to the Fed’s “dot plot,” which shows the projections of Fed policy makers. Chairman Jerome Powell cited healthy economic growth, low unemployment, recent wage increases and low and stable inflation as justification for the most recent increase. A statement that “monetary policy remains accommodative” was removed from the Fed’s statement, reflecting that monetary policy is proceeding in line with the central bank’s expectations.

More Hikes to Come

The Fed is telegraphing additional increases, and with the economy humming along and no immediate market or economic concerns, we anticipate the Fed will continue to build its war chest. We are in the later stages of the economic cycle, and Fed officials want policy tools available for when the cycle inevitably turns. In our view, the pace of hikes will continue to be gradual, with another increase in December, three in 2019 and potentially one in 2020 before the Fed’s ability to tighten is exhausted. We view 3.25% as the likely landing spot for the terminal rate.

Risk in the 5-Year

While market-implied pricing for the forward path of the federal funds rate puts December’s hike at a 77.5% probability, market participants continue to doubt the Fed’s longer-term intentions. Fed fund futures continue to underprice the number of cumulative hikes through the end of 2020, and the yield on the 5-year Treasury note is hovering just under 3%. At some point, the market will need to adjust to the new reality, and we expect to see a dramatic repricing in the 5-year when it does.

Continued Flattening

We expect to see continued upward pressure on the Treasury yield curve, particularly in the front end, as market expectations catch up to the Fed’s. However, longer-dated rates will likely remain range-bound. We are incrementally positive on the economy, but we question the sustainability of growth long term, particularly once the impact of tax reform recedes. And while we are closely monitoring the ability for wage pressures to pass through to inflation metrics, we believe long-term secular trends, such as demographics and the pervasiveness of technology, will ultimately keep inflation in check. We continue to expect a higher, but flatter curve.

A Reassuring Backstop

Risks to both the upward trajectory of the U.S. economy and the exuberance in risk markets remain in play, which in turn could slow the Fed’s pace of tightening. Trade war escalation and emerging market contagion are top of mind. In his press conference, Chairman Powell acknowledged that the economy surprises on a regular basis, and that, if it were to falter, lower rates would again be appropriate. Without inflation forcing the Fed’s hand, the central bank can back off quickly in the event of a material downturn in risk markets or a significant backup in the cost of capital. Investors saw that in 2016, when the Fed held steady through tumultuous markets early in the year. Given this backstop, we believe investors will continue to be well served by dynamically managed fixed income portfolios that can lower exposure to risk assets now at rich valuations and redeploy capital into the credit market at valuations that are more favorable.

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C-0918-19911 9-30-19