Fed’s First Rate Hike of 2017 May Not Be the Last

Fed's First Rate Hike of 2017 May Not Be the Last

As the U.S. bond market has generally expected and priced in for the past two weeks, the Federal Reserve (Fed) has incrementally raised short-term interest rates. It’s the first hike this year and the third time since this rate hike cycle began in December 2015. The Fed raised its overnight rate target range by a quarter percentage point (0.25%) to a range of 0.75% to 1.00%.

Why We Don’t Expect a Big Market Reaction

This new overnight rate target range still represents a historically low, very stimulative level of interest rates. This was an expected Fed move and a logical development in the context of the still historically low level of the fed funds rate versus improvements in the U.S. economy, with attendant higher inflation expectations. This move, in and of itself, is not expected to trigger a big bond sell-off, nor does it signal runaway U.S. economic growth or inflation.

Latest step in Fed’s rate normalization strategy

Today’s increase is expected to be the first of a set of similar rate hikes in 2017, as the Fed attempts to gradually normalize (raise) short-term U.S. interest rates without upsetting the financial markets or the U.S. economy. The Fed wants/needs to normalize its rate target after it’s been so low and stimulative since 2008. The Fed projects two more rate increases this year, with the next one most likely at its June 13-14 policy meeting.

Expect other short-term interest rates to rise

Other benchmark short-term interest rates, securities, and debt vehicles base their rates and rate increases on the actual and anticipated fed funds rate target. These rates and vehicles include U.S. Treasury security yields in the three-month to two-year range, bank lending rates, and adjustable-rate mortgages.

Timing of interest rate reactions vary

It’s worth noting that while bank and other lending rates typically reset after the Fed announcement, market rates such as Treasury yields typically rise or fall before the Fed meeting in anticipation of the move. This also applies to longer-term/maturity interest rates and yields, which are less directly correlated with the fed funds rate.

Higher fed funds rate doesn’t necessarily mean higher longer-term rates

The fed funds rate has a more direct influence on the short-maturity end of the U.S. Treasury yield curve than the long-maturity end, which can be affected by other factors such as inflation expectations, economic growth projections, geopolitical concerns, the relative level of U.S. Treasury yields compared with other comparable sovereign yields world-wide, and technical factors such as supply and demand. As the Fed raises the short end of the yield curve, the longer end often stays more static, resulting in a flatter—or flat—Treasury yield curve.

Global and Trump risks could flatten the U.S. yield curve, slow normalization

Similar to the last two years, when the Fed projected multiple rate hikes but made just one each year, policy makers may be restricted by global events, such as European election results, current U.S. politics and policies and China’s growth.

The Fed really wants to normalize, but it also doesn’t want to further upset the economy and financial markets if/when they’re stressed by other factors. The potential geopolitical instability factors—both in the U.S. and around the world—are reasons why we’re still not sure if the Fed will achieve its target of two more rate hikes this year. Just one more is possible, in our view.

We Expect Range-Bound Long-Term U.S. Interest Rates

The long-maturity end of the U.S. Treasury yield curve has been range-bound since surging in November after the U.S. elections. We think the 10-year Treasury yield will be in a range of 2.06% to 3.16% a year from now. Global economic and financial market conditions continue to lean against major upward movements in long-term interest rates. Most notably, the European Central Bank and the Bank of Japan are still buying bonds.

More of our outlook coming

Watch for more of our insights on the Fed, other macroeconomic factors, and investment views from our portfolio teams in the second quarter 2017 Investment Outlook, scheduled to be posted on our website by early April.

Generally, as interest rates rise, bond values will decline. The opposite is true when interest rates decline.

The opinions expressed are those of Dave MacEwen and are no guarantee of the future performance of any American Century Investments portfolio.

For educational use only. This information is not intended to serve as investment advice.