Thomas Garretson, CFA
Senior Portfolio Strategist
Fixed Income Strategies
Portfolio Advisory Group – U.S.

Though the Federal Reserve has yet to formally announce its plans for curtailing monthly asset purchases, an announcement we expect at its Nov. 3 meeting, the market is already looking beyond the tapering process to what the next rate hike cycle might look like—and, more importantly, when it might start.

As the first chart shows, the market is now priced for approximately two rate hikes of 0.25 percent each by the end of next year (whereas just one month ago it didn’t expect any), followed by a further two hikes in 2023. The Fed, for its part, signaled at its September meeting that it is divided on the likelihood of even one hike next year; this implies the potential for three rate hikes in 2023, but the Fed’s expected endpoint remains below market expectations.

The market’s rate expectations are now well ahead of Fed guidance

Fed rate projections

Market rate expectations

Federal funds rate

Source - RBC Wealth Management, Bloomberg, Federal Reserve September Summary of Economic Projections; data as of 10/21/21

The phenomenon of markets pulling forward the timing of expected rate hikes isn’t exclusive to the United States; the same dynamic has emerged in many developed market economies. The most intense action has so far been in the UK, where RBC Capital Markets now expects the Bank of England to begin raising rates as early as this Dec., rather than in mid-2022 as previously expected. Our colleagues now anticipate a 0.25 percent rate hike in Dec., followed by 0.15 percent in Feb. 2022, and yet another 0.25 percent in Aug. of next year.

It appears that markets now see higher-than-anticipated inflation as likely to force the hands of central bank policymakers, who have to this point largely pledged to be patient with respect to tightening policy. For investors, this raises the question of whether markets have gotten ahead of themselves.

Inflation may be driving inflated interest rate expectations

While there are ample supply-side shortages in the world today, there is no shortage of challenges for central banks. One is that higher interest rates probably aren’t the answer for the shortages, the supply-side bottlenecks, and the more-persistent inflationary pressures that have resulted from them, even if markets expect central banks to respond with rate hikes.

A second—and real—challenge for central banks is that regardless of its root cause, high near-term inflation could morph into higher long-term inflation expectations. This is the more important concern, in our view.

However, there are few signs of higher long-term expectations becoming a problem. In the U.S., the Federal Reserve Bank of Cleveland splits Consumer Price Index data into two categories: “flexible” prices—those more sensitive to economic factors, such as motor fuel, car rental, natural gas, used cars, and hotels—go into one bucket. The rest—prices that are more stable and more sensitive to inflation expectations, such as apparel, rents, communication, and medical care services, go into the “sticky” bucket. It’s the sticky bucket that tends to attract the attention of central banks, and thus far, sticky prices remain stuck in low gear. Currently, the Cleveland Fed’s index of sticky prices is rising at a pace of 2.7 percent y/y, compared to a 14 percent y/y rate of increase for flexible prices.

The same dynamic can be seen in consumer data. The University of Michigan Survey of Consumers showed one-year inflation expectations rising to a decade-high 4.8 percent this month, while long-term inflation expectations remain anchored at just 2.8 percent, roughly equal to the average over the past 10 years.

For now, our view remains that the first Fed rate hike is still a long way down the road, perhaps arriving late next year, and that there are more important issues to consider than the timing of rate hikes.

It’s not how you start, but how you finish

While global markets are currently wringing their hands over the timing of rate hikes, we expect their concern will soon shift to the bigger idea of how high policy rates could rise this time around.

Keeping the focus on the Fed and the U.S., the second chart shows that a significant gap remains between how high the Fed thinks its policy rate will go—2.5 percent—and the more modest 2.0 percent expectation of a panel of market participants surveyed by the New York Fed. The ultimate policy rate will have implications for the benchmark 10-year Treasury yield, a number that reverberates through equity and fixed income markets in the U.S. and around the world.

The peak level for the Fed’s policy rate is likely to dictate peak levels for longer-term Treasury yields
Evolution of “neutral” long-run policy rate estimates vs. 10-year Treasury yield
Federal Reserve
Survey of market participants

10-year Treasury yield

Source - RBC Wealth Management, Bloomberg, Federal Reserve Bank of New York Survey of Market Participants; data as of 10/21/21

In 2018, three important numbers converged on a single value: the Fed’s view of the long-run policy rate, the market’s view of it, and the 10-year Treasury yield all came together at 3.0 percent. We expect a similar process to play out this time around; the question is whether the final number will settle at 2.5 percent, 2.0 percent, or even somewhere higher or lower. In our view, something closer to 2.0 percent would be a reasonable expectation at this stage.

Slow and low

The first rate hikes from major global central banks may indeed arrive earlier than previously anticipated. But in our view, an earlier start will likely translate to a more gradual pace, and ultimately to lower peak levels.

Where we previously expected the 10-year Treasury yield could rise toward 2.50 percent over the next year or two, we now think that number could end up as low as 2.00 percent. Peak levels could be even lower than in the past, and they could be here sooner rather than later. The potential implication is that although fixed income yields have risen of late, they might not actually have that much further to go—and consequently, investors will have to be more proactive in adding yield to portfolios.

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Thomas Garretson, CFA

Senior Portfolio Strategist
Fixed Income Strategies
Portfolio Advisory Group – U.S.
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