Marching Toward a Fed Rate Hike

Marching Toward a Fed Rate Hike

It’s understandable if investors are feeling overwhelmed by recent political, economic, and financial market events. President Trump’s election set off a frenzy of political and policy activity in the U.S., causing rapid adjustments (and re-adjustments) to U.S. economic growth and inflation expectations.

Meanwhile, global political and economic conditions are no less frenetic. There have been worldwide reactions to Trump and his policies, as well as nationalistic/anti-globalization political themes running through Europe. Other concerns include China’s increasing growth and influence, Russia’s gambits outside its borders, Japan’s attempts to spur growth, and the seemingly always-volatile Middle East situation. In other words, there’s a lot of uncertainty.

Finding Clarity in Uncertainty

Uncertainty is the big economic buzzword right now. Even the Federal Reserve (Fed) is using it more in its discussions, as the minutes of its policy meetings reflect. Recent financial market behavior demonstrates this uncertainty—while the U.S. stock and corporate bond markets have continued to rally, longer-maturity U.S. Treasury yields have been range-bound since their post-election November surge. These behaviors show that there are questions about the U.S. political and economic outlook, conditions overseas, and the continued low interest rate environment in Europe and Japan.

Despite this uncertainty, there’s been increasing clarity on at least these U.S. fronts:

  • The Fed wants/needs to normalize (raise) its short-term interest rate target after it’s been so low and stimulative for so many years (since 2008).
  • The U.S. economy appears to have achieved a state of sustainable growth. The labor market and corporate profits are improving. And if President Trump can achieve his goals, fiscal stimulus is on the way.
  • Inflation is increasing, from low levels toward the Fed’s 2% target level. Inflation could receive increasing upward pressure from President Trump’s proposed fiscal stimulus.

What We Think the Fed Will Do

Modest March rate hike likely coming

It’s looking increasingly likely that the Fed will raise its overnight interest rate target on March 15 by another quarter percentage point (+0.25%) to a range of 0.75% to 1.00%. This is still a historically low, very stimulative rate. Bond market futures are now pricing in the odds of a March rate hike at 90%.

Expected gradual pace of rate hikes

This would be the first of a series of similar expected Fed rate hikes in 2017, as the Fed attempts to gradually normalize short-term U.S. interest rates without upsetting the financial markets or the U.S. economy.

Longer-maturity Treasury yields remain range-bound

Looking at U.S. Treasury yields, short-maturity yields have climbed in conjunction with increasing Fed rate hike expectations, but longer-maturity yields have remained mostly range-bound since they spiked in November. This has caused the Treasury yield curve to flatten. Some reasons the longer-maturity yields have remained range-bound include U.S. and global political and economic uncertainties, low European and Japanese interest rates, and modest/moderating inflation expectations since they spiked in November.

Our Expectations

For these reasons, we believe the Fed will continue on its present path of gradual interest rate increases. Treasury yields will also rise, probably more so on the short-maturity end of the yield curve than the long end, causing the Treasury yield curve to flatten. This flattening is typical during periods of Fed rate increases. Twelve months from now, we think the 10-year U.S. Treasury yield will be in a range of 2.00% to 3.20%, given present global political, economic and financial market conditions.

Finally, we believe curve flattening will be supported by the influence that U.S. and global factors have on the long-maturity end of the curve. While President Trump has significantly altered the U.S. political landscape, global economic and financial market conditions continue to lean against major upward movements in long-term interest rates.

Note: We plan to update this outlook after the Fed releases its statement after the March 15 policy meeting.

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.