Schroders Quickview: Fed keeps rates on hold, but for how much longer?

Lisa Hornby

Lisa Hornby

US Fixed Income Portfolio Manager

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Rates on hold and future expectations muted

At Thursday’s meeting, Fed officials left monetary policy on hold and opted not to guide towards an imminent interest rate hike.

Their statement reflected a slight improvement in the economic outlook as they removed the reference to global developments continuing to pose risks.

They continued to acknowledge strength in the US labour market even as growth in economic activity has slowed.

Nine members voted with the committee while one policy member dissented, preferring to increase rates by 25 basis points (bps) at this meeting.

Expectations were muted coming into the meeting with the market pricing in the next 25bps increase in the funds rate in January 2017, and one 25bps hike each year thereafter.

Market reaction

The fixed income market reaction to the statement was relatively subdued, with 10-year Treasury yields rallying by 1-2 bps, to 1.87%, in the minutes following the statement.

There was little discernible reaction in credit markets.

Risk markets declined during the first six weeks of the year, causing the Fed to backtrack on its more hawkish rhetoric following their December hike, where they lifted rates from near zero levels for the first time since 2008.

The Fed’s most recent Summary of Economic Projections, published in March, contained a downgrade to their expectations for future rate hikes and for the ultimate terminal rate.

Financial conditions have improved significantly over the past two months, with stocks 2.5% higher and broad market credit spreads1 10bps tighter year-to-date.

Dollar strength has also subsided with the trade-weighted dollar depreciating by 2.5% since 31 December.

June too early, but two hikes still a possibility

Despite these positive developments, the Fed decided not to signal a June rate hike by describing risks as “nearly balanced”, the way that they did in October ahead of their December move.

It is our expectation that the Fed will hike once or twice in 2016, which will cause a gradual re-pricing in Treasury yields – particularly at the front end of the curve.2

1. A credit spread is the difference in yield between two bonds of similar maturity but different credit quality.

2. A yield curve is a line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity dates. They can be used as a benchmark for other debt in the market, such as mortgage rates or bank lending rates. The curve is also used to predict changes in economic output and growth.