September 8th, 2016 | By Nick Sargen
Over the longer term, our assessment is the funds rate will rise somewhere between the path the Fed expects and the one that the bond market is pricing in. If so, it would likely pose a headwind for the stock market and other risk assets.
After pursuing unorthodox policies that were designed to bolster the U.S. economy and financial markets through record low interest rates, the Federal Reserve has spent the past three years attempting to normalize interest rates. Fed policymakers first made sure they had adequate tools to mop up excess liquidity in the banking system including charging interest on excess reserves. The message officials conveyed was that they were up to the challenge of raising interest rates once the economy was on solid footing as reflected in low unemployment and core inflation close to 2%.
The experience of the past three years, however, suggests the challenges to raising interest rates, in fact, are more formidable than Fed officials expected due to a series of unforeseen developments. The initial attempt to begin normalization occurred in the spring of 2013, when Chairman Bernanke announced the Fed was considering phasing down its quantitative easing (bond purchase) program during 2014. While officials thought they had communicated a message that would give market participants time to adjust to policy changes, the announcement caught the markets completely off guard and long-term bond yields spiked by a full percentage point to 3%. Thereafter, officials went out of their way to reassure investors that they were in no hurry to raise interest rates, and bond yields subsequently retraced this rise.
It was not until 2015 that Fed officials actively considered raising interest rates, when the unemployment rate declined towards 5%, a level that many economists consider to be close to full employment. This time, Fed officials sent a clear message in the summer that they were prepared to act, and market participants were anticipating a move at the September FOMC meeting. Instead, the Fed held off from acting when global markets turned turbulent. It was only after markets had calmed in December that they finally acted to raise the funds rate by one quarter of a percentage point. At the time, Fed officials were optimistic about the economy’s outlook, and their consensus forecast called for four additional moves in 2016.
So far this year, the Fed has failed to act due to a combination of turbulence in global financial markets and modest U.S. economic growth in the first half of this year. Nonetheless, three prominent leaders of the Fed – the Chair Janet Yellen, the Vice Chair Stanley Fischer, and New York Fed President William Dudley – have put the markets on notice that it could resume raising interest rates as soon as this month’s FOMC meeting on September 20-21 and that another rate hike is possible before the year is over. The case for tightening is that the economy appears to have gained traction this quarter, with consumer spending buoyant and the reduction in inventories expected to reverse. Jobs growth has also been solid, averaging 230,000 per month in the past three months, even with more modest growth in August. At the Jackson Hole conference in late August, for example, Chair Yellen offered the following assessment:
“In light of the continued solid performance of the labor markets and our outlook for economic activity and inflation, I believe the case for an increase in the federal funds rate has strengthened in recent months.”
For their part, market participants remain skeptical that the Fed will act, considering that the economy has struggled to maintain the 2% real GDP growth trend since the expansion began, and economic growth abroad in Europe and Japan is softer. Also, wage increases continue to be moderate and the trend in core inflation is still below the Fed’s 2% target. Accordingly, the bond market is pricing in only a one in three chance the Fed will raise rates this month.
In these circumstances, investors are wondering how markets will fare depending on the Fed’s response. Our assessment is that the decision is likely to be close, but the most likely outcome is the Fed will delay tightening until it has clearer evidence that the economy is reaccelerating from a slow first half. In that case, we would not expect a large market response.
Should the Fed act, on the other hand, markets are likely to turn more volatile, with the yield curve rising (and flattening) while the stock market and other risk assets are likely to sell off. In this case, market participants would closely monitor the FOMC statement to understand the basis for the decision and also to assess the possibility that the Fed could move again in November or in December.
As regards the medium term outlook, our view is the timing of Fed actions this year is less important than the glide path for the funds rate over the next couple of years. Currently, there is a wide dispersion between what Fed officials believe is likely and what bond market participants are expecting. (See Figure 1 below.) By end 2018, for example, the bond market is pricing in a funds rate of less than 1% compared with 2.5% for Fed officials.
Figure 1. Fund Rate Projections: The Bond Market vs. the Fed’s View
In this regard, we recognize that the bond market thus far has done a better job anticipating where the funds rate will be than Fed officials have in their projections. Nonetheless, we believe bond market participants are too pessimistic about the economic outlook for 2017-2018, and our own forecast is that the path of the funds rate will be somewhere between these two paths. If so, it would imply higher long-term yields than are currently priced into bond markets and a stronger U.S. dollar. At the same time, it would imply a greater impediment to the stock market and other risk assets such as high-yield bonds and emerging markets.