Market Views: Fixed Income
Schroders Quickview: Fed hikes rates but it's all about the pace
The Federal Reserve signals lift-off for interest rates in the US, but the pace of future rate hikes could be called into question.
It has been exactly seven years, to the day, of zero interest rate policy in the US.
After months of pontificating as to when the Federal Reserve (Fed) would move, they have finally delivered a 25 bps increase in rates.
Controlling the money supply
This time around, the Fed is implementing a new method of tightening due to structural changes in markets since the 2004-2006 tightening cycle.
They will be setting a range as to where the Federal funds rate should sit by moving the reverse repo1 rate to 25 bps and interest on excess reserves to 50 bps (from 5 bps and 25 bps respectively).
The latter two markets did not exist in prior tightening cycles.
The Fed also announced that they will maintain their $4.5 trillion balance sheet by continuing to reinvest maturities until normalization is well under way.
The decision was unanimous amongst the Federal Open Market Committee (FOMC) participants.
The market reaction following the announcement was relatively muted:
- US 2-year Treasury yields rose 4 bps throughout the course of the day to 1.00%
- US 10-year Treasury yields moved by a similar magnitude towards 2.30%.
- Risk assets2 fared well as the rate hike was tempered by a somewhat dovish view of the tightening cycle; credit spreads3 have tightened on the day while equity markets have continued to rally.
- The dollar reaction, despite concerns amongst many market participants, was also benign.
Markets had largely expected this move as the implied probability (derived using Fed funds futures) of a December rate hike had risen from 25% to roughly 80% over the last three months.
Setting the pace
The conversation over recent weeks has been largely about the pace of the hiking cycle.
Fed Chair Janet Yellen assuaged fears of a rapid pace of hikes by stressing that further hikes will be both gradual and data dependent.
However, it is worth noting that the Fed still foresees four 25 bps rate hikes in 2016, while the market is pricing in only two.
Four hikes over the course of a year would be a historically slow pace compared to previous cycles.
To put this in perspective, during the 2004-2006 rate hiking cycle, the Fed hiked eight times in the first year of lift-off.
Of course, we know that “this time is different” and that there are various reasons why potential growth has shifted structurally lower, and therefore requires a lower neutral Fed funds rate.
However, we believe this gradual pace will be increasingly called into question over the next several months.
The performance of risk assets, the dollar and the global backdrop will be key in determining the future of Fed policy.
1. Reverse repo rate: the rate at which the central bank of a country borrows money from commercial banks within the country. It is a monetary policy instrument which can be used to control the money supply in the country.↩
2. Risk asset: Risk asset generally refers to assets that have a significant degree of price volatility, such as equities, commodities, high-yield bonds, real estate and currencies.↩
3. Credit spread: The difference between Treasury securities and non-Treasury securities that are identical in all respects except for quality rating.↩