While bond market prognosticators are confident the Federal Open Market Committee will raise the fed funds rate target by 25 basis points this week, they remain less certain on the outlook for 2019.
The markets are expecting the new Summary of Economic Projections, or dot plot, to be more dovish than the one released in September. While economic data has been mostly solid — and Fed officials have said that once rates reach a neutral level future hikes will be data dependent — market volatility, trade issues and a decline in inflation expectations are likely to slow the Fed, observers say.
“The market should be careful what it wishes for,” said Bryce Doty, senior vice president/senior portfolio manager at Sit Fixed Income. “A dovish Fed can often lead to higher bond yields if they appear too sanguine about inflation pressures. Basically, the Fed can’t win regardless of what they do on the 19th. As a bond investor, play the trading range on yields. Get defensive before inflation data (Be wary of wage growth sustaining a 3.0% plus rate because, at some point, those labor costs will get passed through). And be brave after inflation expectations have rebounded. Hold off a little longer on moving heavy into credit as corporate bond spreads have further room to widen as Chicken Littles panic over yield curve inversions.”
Nothing can stop this week’s hike, Doty said. “The key will be to listen to the press conference to discern if the Fed will slow their pace of rate increases next year. We expect the Fed to reach 3.0%, say they are ‘neutral,’ and pause on the rate increases while they continue to work down their balance sheet,” he added.
“We see the December FOMC meeting producing a dovish hike, wherein the Fed further affirms a shift to a nimble regime, while also shifting its projected hiking path and economic projections downwards,” wrote BNP Paribas’ U.S. research team. They also expect the interest on excess reserves to be raised only 20 basis points, the second such technical adjustment by the Fed to “keep the effective fed funds within its upper and lower bound.”
And BNP expects the Fed to continue with quarterly hikes until June before pausing.
And while the BNP team, led by Economist Andrew Schneider, doesn’t expect any mention in the post-meeting statement about yield curve inversion, that topic could pop up in Chairman Jerome Powell’s press conference or minutes of the meeting.
“We would agree that inversion is an important signal, however interpreting this signal is very difficult, diffusing its usefulness,” they write. “In more recent cycles, the yield curve has remained flat/inverted for varying amounts of time as the Fed finished hiking (up to one year), leading to varying amounts of time (9-18 months) between the last hike and economic slowdown/first rate cut.”
Bill Merz, director of fixed income at U.S. Bank Wealth Management, agrees about the
The Fed is likely to project two rate hikes in 2019, down from the September median estimates for three, with “financial conditions remaining under pressure, wider credit spreads (the difference in yield between risky bond yields and comparable U.S. Treasury yields), the yield curve flattening, inflation expectations falling and continued uncertainty around the impact of trade negotiations on economic activity.”
Arthur Bass, managing director of fixed income financing, futures and rates at Wedbush, is also on board with the December hike and 20 basis point IOER raise. But, he believes, the Fed is going to be data dependent going into 2019. In a
The latest employment report and the consumer price index cemented the December rate hike, according to Luke Tilley, chief economist at Wilmington Trust. “However, … we think the Fed is set to slow the path of rate hikes in 2019. As of today, the median FOMC participant expectation is for three hikes in 2019, and we think it will only be two hikes, based on our current outlook. We would not be surprised if the new projections reflect the same downward adjustment.”
Tilley pointed to the continued flattening of the yield curve and the drop in “longer-term inflation expectations as measured by TIPS breakevens in the Treasury market” as the major reasons the Fed will need to slow down. The yield curve “will give more pause to this FOMC and this Chairman than committees of the past, in our view,” he said.
“The Fed as an institution gets very nervous when long-term inflation expectations appear to be getting either too high or too low,” Tilley said. “That is much more worrisome to them than reports of current inflation or any market movements.”
Wilmington Trust believes “inflation is very much under control and will not move too much higher from where it is today,” as a result of stronger productivity, which it expects to continue. “This acts to keep inflation low going forward. That will prevent the Fed from hiking very aggressively in the next couple of years, and we think they ultimately will not hike past the 3.25% mark,” Tilley said. “That is lower than their current projections, and only slight above ‘restrictive levels’ based on their current assessment of the longer term neutral rate.”
While Gary Pzegeo, head of fixed income at CIBC Private Wealth Management, expects a 25 basis point hike to 2.25% to 2.50% at this meeting, he said, the end of the Fed tightening cycle may be in view.
The three- to five-year and two- to five-year spreads recently inverted, and while those segments are not the focus of the markets, they are “indicative of the broader trend in the curve that has been underway for several months. Most have focused on the difference between 10 and 2 year yields, which is still positively sloped, but only by a very small amount,” Pzegeo said.
“The Fed seemed to discount the value of this signal recently and, instead, focused the market’s attention on the difference between the very short end of the curve as having more significance in predicting recessions,” he added. “This segment, the 18-month and three-month fed funds futures yield has flattened significantly over the last month and may be signaling a slowdown and expected end to the Fed’s tightening cycle.”
Wells Fargo expects three increases next year, bringing the fed funds rate to a range of 3.00% to 3.25%. “We also see the Fed slowing or ending its balance sheet reduction in 2019 or early 2020,” George Rusnak, co-head of global fixed income strategy for Wells Fargo Investment Institute, wrote in a report. “A key concern is that the Fed might become too aggressive raising interest rates. A Fed policy misstep — even if it occurs in slow motion — is an increasing risk, in our opinion.”
As for the yield curve, he wrote, investors should look at “the 10-year minus the 1-year Treasury yield. If this indicator turns negative for at least four weeks or inverts by more than 25 basis points, we would see that as the bond market sending a cautionary signal.”
Mark Heppenstall, CIO at Penn Mutual Asset Management, said, “the Fed is approaching the end of this tightening cycle. The economy clearly has responded to previous rate hikes, and has responded to the quantitative tightening that is now being implemented at the full level within their schedule to reduce the size of the balance sheet. To Fed officials, I think that has been a surprising outcome, given the strength in the labor market, that we would start to see weakening in certain parts of the economy so quickly. Even though the 3-year duration of the current tightening cycle has been long relative to previous cycles, the absolute volume of the rate increases has been modest.”
The impact of the increases to date, he suggested, “has been greater than they would have estimated just a few months ago.”
While the December hike is expected, Heppenstall sees one in 2019, “but zero hikes next year remains a possibility. Extreme volatility in the equity market, slowing growth that you’re seeing elsewhere across the globe, corporate profit growth peaking and less fiscal stimulus next year — all factor to higher odds the Fed hikes in December and stops there.”
Duane McAllister, managing director and senior portfolio manager at R.W. Baird, said “the Fed is attempting to navigate through unchartered territory – returning to ‘normal’ from such an unprecedented extraordinarily easy monetary position has never been done. Mistakes may occur, either in terms of policy itself or in how it is communicated.” While Powell and Vice Chairman Richard Clarida have done well on both scores, “heightened market volatility in bond prices and credit spreads is expected through this process,” McAllister said.
As for when the Fed ends its hiking cycle, McAllister said, “No one knows, not even the Fed.”
After two hikes in the first half of 2019, the Fed will pause, according to Keefe, Bruyette & Woods Global Director of Research Fred Cannon in a financial stocks outlook report. “This would put the upper bound of the fed funds rate at 3%, at approximately what most economists feel is a neutral rate for the economy.”
Slower economic growth, with little indication that inflation will accelerate, will stop the Fed. “We expect bond yields to move toward 3.5%, keeping the yield curve flat, but not inverted. For most banks and other financial firms dependent on net interest income, this scenario would result in net interest margins remaining flattish through next year,” Cannon wrote.
If the Fed pauses in mid-2019, a soft landing is possible, he noted. “[C]ontinued Fed rate hikes would likely push up the value of the dollar, put downward pressure on inflation, widen credit spreads and result in lower bond yields and a negative yield curve. All those factors would be bad for most financial stocks.”
Berenberg Capital Markets expects just one hike in 2019, after a December bump, which boosts the fed funds rate “above inflation for the first time since 2008.”
The revision from two expected hikes to one is based on “a host of factors,” wrote Berenberg Chief Economist Mickey D. Levy, and U.S. Economist Roiana Reid. “Importantly, Chairman Powell and other Fed members have become more circumspect about their assessment of the natural rate of interest (neutral monetary policy) and do not want to harm the economy.”
