The U.S. Federal Reserve has just raised rates for the third time in 2017 and the fifth time since 2015, moving further away from zero where it sat for seven years since the 2008 global financial crisis.
How much further will rates rise in the near term and how fast? Will the new U.S. Fed chair spur a change in policy direction at the central bank? Craig Bishop, vice president and lead strategist for U.S. fixed income strategies at RBC Wealth Management, discusses what's driving rates higher, what to expect from the new Fed chair, and how these moves might impact investors in the year ahead:
Q. Can you provide some historical context as to why rates are moving up?
For that, we should begin with the Great Recession of 2007-2009. That was when the Federal Reserve began to resort to new, extraordinary measures of monetary stimulus, which has dictated the course of policy and rates since. It was December of 2008 when the Fed took its benchmark rate down to zero. It stayed there for seven years until December 2015, when the Fed began to slowly normalize monetary policy. From 2008 to 2015, seeing that their zero interest rate policy alone wouldn’t be enough, the Fed took a number of additional measures to stabilize the economy, to bring it back from the edge of the cliff.
To me, it was partly a recognition by the Fed that the economic downturn was more than a run of the mill correction. In my view, it was second to the great depression back in the 20s and 30s as far as severity. It wasn't until two years ago that the Fed believed the economy had stabilized to the point where it felt they could begin raising rates.
Q. What message has the Fed sent with hikes in the past two years?
The message it has been sending is that the rate hikes aren't tightening, they're not designed to slow the economy down, and they’re meant to get short-term interest rates back to more normal levels. In doing so, the Fed is going to be slow and patient. It has moved rates in 25-basis-point increments. I don't see the Fed varying from that unless we get to the point where the economy begins to really take off and inflation pressures move sharply higher.
Q. What's driving the latest rate increases?
It's part proactive and part reactive. The Fed wants to continue to move off that zero-interest-rate level it had kept for so long. When the next recession happens, it wants to have some ammunition to make policy changes to soften the blow. The economic and financial indicators we follow are all flashing ‘green’ which tell us a recession is not on the horizon; at the earliest it could be a 2019 event. Having an arrow in its quiver is part of that reason, but I think it's also the strengthening economy. Unemployment is at its lowest level in about 17 years, at 4.1 percent1, and there's a good chance it could move below 4 percent at some point. Inflation, while below the Fed's 2-percent target, isn't an issue right now. I think those are all things that continue to give the Fed the encouragement and confidence to gradually raise rates.
Q. What can we expect from the new Fed chair?
I'm a fan of outgoing Fed chair Janet Yellen. She's done a great job guiding monetary policy. Her slow and gradual pace is just what the doctor ordered. Incoming chair Jerome Powell, who replaces Yellen when her term expires in February, should be a steady hand at the helm. He has expressed a commitment to the 'steady as she goes' policy Yellen began. It should be a somewhat seamless transition.
Q. Do you see a change in course?
With regard to monetary policy, no. Where the change could come, given Powell’s background, there's an expectation he might be a proponent of easing regulations in the financial sector2. That's just an opinion out there right now. He didn't express any of that in his nomination hearing.
Q. How may U.S. tax reforms impact the economy and future rate moves?
Our view is that the tax reforms will be beneficial to the economy. With lower corporate and individual tax rates, the benefits should flow into the economy and help to spur growth. That said, they may not provide as much stimulus as some hope, particularly when it comes to individual taxpayers.
The impact of tax reform could be the wild card as to what the Fed does and what interest rates do. If the tax changes do prove to be extremely stimulative, then I think that causes the Fed to become a little less patient and maybe take a more aggressive stance in raising interest rates. What happens over the next nine months or so, once all of the tax reforms are finalized and the impacts start to flow into the economy, will determine what happens with rates.
The Fed will not move interest rates or be more aggressive in anticipation of something. It will be patient and wait until it starts to see the numbers. The Fed is very data dependent.
Q. What's your prediction for rates longer term?
The December hike wasn't a surprise. The Fed has forecast three hikes for 2018. At this point, given the discussion about low levels of inflation, we think that if nothing changes, it could turn into two rate hikes; the Fed will be more patient. We think the next hike could come in March; I wouldn't be surprised to see that. At that point, if there aren't any changes in the overall level of inflation and the economy hasn't moved significantly, the Fed could pass in June as it waits for more data and another rate hike later in the year — September or December. As for longer term rates, we don’t see anything on the horizon which would result in a significant shift higher from current levels of ~2.40 percent on 10-year Treasuries. The Fed’s current projection is for a 2.75 percent terminal Fed Funds rate which is where their benchmark rate should sit at the end of this rate hike cycle (~2020). In past rate hike cycles short and long-term rates converge on this level, in 2006 it was 5.25 percent. For this cycle it will be much lower – 2.75 percent per the Fed’s forecast – and we think this will act as a cap on ten-year rates.
Q. Why should investors follow these Fed rate moves?
From an individual standpoint, the adjustment will potentially impact everything from the interest rate on their credit cards, loans and mortgage rates. It could benefit their short-term investments in certificates of deposit, for example.
If rates continue to march higher longer term, it will mean more attractive rates for investors — something that has been desired for quite some time. Higher rates will also impact what happens in the equity market, in different ways. Our view is that rates won't move sharply higher. They'll be fairly well contained as the Fed maintains its gradual approach.
Q. What's the global trend?
The Fed has been on this path of normalization for two years. We're starting to see other global central banks normalize interest rates too. Overall, the global economy has finally begun to recover from the recession. As a result some global central banks are now comfortable unwinding the stimulus measures they had also put in place. Similar to the Fed, they're not doing it to tighten or inhibit growth; they're doing it because these economies have weathered the storm from the 2007-2009 recession and can stabilize on their own. From an investor's standpoint, it means the world economy is in better shape.
Interest rates will move higher, which will help lift not just bond yields, but will make equity markets more attractive, too. To me, that's the real positive. Central banks aren't raising rates to slow down growth, rather their current policies should support continued growth, but they also feel it’s time normalize monetary policy
1 As of October 2017
2 Powell is a lawyer by training, an investment banker by trade and has been on the Fed board since 2012.