Higher And Higher: The Fed Continues To Hike


June’s increase in the Federal Funds target rate reflects the Fed’s continued confidence in the near-term U.S. economic outlook.

Fed officials increased the projection for future rate hikes, and we are closely monitoring the divergence in Fed and market expectations, as this could be a source of market volatility.

While our base case is for higher rates and a flatter Treasury curve, there are geopolitical concerns in play that could incite a risk-off mindset and pause the rise in global rates.

By Darrell W. Watters & Mayur Saigal

On Wednesday, the Federal Reserve (Fed) increased the Federal Funds target rate by 25 basis points for the second time in 2018. The Fed's target rate now ranges from 1.75% to 2%. Recent data supported the decision, with inflation creeping above the Fed's 2% target and unemployment sitting at 3.8%. Given the strong economic data and their confidence in U.S. economic conditions, Fed officials are now forecasting a total of four hikes in 2018, up from three. Language indicating that the Federal Funds rate would likely remain below long-term levels "for some time" was also removed from the policy statement. Treasury securities sold off immediately following the announcement, as markets reacted to this more aggressive stance.

Given that Wednesday's statement seems to indicate a more hawkish Fed posture, we remain concerned that investors are underestimating the Fed's resolve. The Fed is suggesting six more hikes by 2020's end, while Fed Fund Futures are pricing in approximately three hikes over the same period.

Barring a major risk-off event, we now believe that another two hikes this year will come to fruition. We expect these and future hikes to remain measured at 25 basis points each. As the Fed continues to push through rate increases, U.S. Treasury securities become relatively unattractive to foreign buyers due to higher hedging costs. This - in combination with an increase in Treasury issuance to fund fiscal stimulus - should also push rates higher. However, the Fed did not revise its long-term growth projection which suggests that the conditions are right for a higher, but flatter Treasury curve. It may be a bear market to the five-year, but the stable long-term outlook from the Fed should keep the long end of the curve range-bound.

Still, volatility is here to stay, in our view, and we believe there are a number of geopolitical risks, including trade wars, that could incite a risk-off mindset and put the rise in global rates on pause. Most immediately, we will be focused on language from the European Central Bank (ECB). A move to end quantitative easing (QE) measures in September would be interpreted as hawkish and support rising rates in developed markets. Middle ground, and the most likely course of action, would be an extension of asset purchases at a lower dollar amount through year-end. Failure to scale back the program, or any direct mention of Italy's eurosceptic challenges, could cause investors to seek safety and suppress the upward movement in rates.

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