As expected, the Federal Reserve (Fed) left its interest rate target unchanged at its latest monetary policy meeting. This is consistent with the gradual pace and shallow path of interest rate normalization we’re expecting from the Fed, and gives its policy makers more time to see how economic and political developments unfold this year, particularly in the U.S., Europe and China.
Meanwhile, the Fed also provided guidance on future policy moves, including possible interest rate hikes later this year, and reductions in its balance sheet (its portfolio of Treasuries and agency mortgage-backed securities).
Three Small Steps, Then a Pause
The Fed maintained its overnight rate target range at 0.75% to 1.00%. The target was 0.00% to 0.25% in December 2015, when the Fed initiated its rate normalization campaign with a quarter- percentage-point (0.25%) hike. The Fed also raised its rate target in December 2016 and March 2017 by 0.25% each time.
Why the Gradual Pace and Shallow Path?
The Fed is the only major central bank on a rate hike path. Other major central banks, most notably the European Central Bank and the Bank of Japan, are still providing massive amounts of monetary stimulus (low interest rates, and bond purchases). This is expected to be replaced in coming years by increasing amounts of fiscal stimulus (government spending). Meanwhile, inflation, while showing signs of increasing in the U.S. and Europe, still isn’t a major threat.
The Fed is also attempting to gradually normalize short-term U.S. interest rates without upsetting the financial markets or the U.S. economy. Fed policy makers don’t want a repeat of 2013, when just the hint that the Fed might be reducing its bond purchases (quantitative easing, which ended in 2014), caused U.S. Treasury yields to spike. Now the Fed is trying to telegraph its intents and targets more clearly.
We Expect More Fed Rate Hikes, But Not a Big Bond Sell-off
The Fed still wants/needs to further normalize its rate target after it’s been so low and stimulative since 2008. Under present economic conditions, we expect the Fed to execute two more 0.25% rate target increases this year, with the next one most likely at its June 13-14 policy meeting. We do not expect the Fed to begin reducing its balance sheet until after it has further normalized its interest rate target.
We also do not expect near-term Fed moves to trigger a big bond sell-off. While the Fed can directly manipulate short-maturity interest rates, longer-maturity rates and yields are more market driven, susceptible to conditions such as supply and demand for bonds, geopolitical uncertainties, and expectations for inflation and economic growth. In the near term, we believe the main drivers of interest rate direction will be expectations for economic growth and inflation, influenced by what President Trump’s administration accomplishes in terms of tax reform and fiscal spending plans.
Market conditions have kept long-maturity U.S. Treasury yields range-bound since they surged in November 2016 after President Trump’s victory. The president’s pro-growth agenda led markets to anticipate stronger economic growth and higher inflation in 2017-18, but his full agenda has proven difficult to implement as quickly as hoped. “Trump Reflation” expectations have also waned, especially in the U.S. bond market. We think a 10-year Treasury yield range of approximately 2.20% to 2.80% will continue to hold for much of this year, barring a big change in U.S. or global economic conditions.
Updated Fed and Interest Rate Outlook in June
We plan to update our rate outlook when the Fed’s policy committee meets June 13-14. Between now and then, France will hold its second round of presidential elections and we’ll see two more U.S. employment reports. Additionally, the Trump administration will continue to attempt to further clarify and move forward its fiscal and foreign policy agendas, with anticipated Congressional headwinds. All of this will provide plenty of new information for the Fed, and the markets, to digest in June.
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.