The Federal Reserve’s current “dot plot” (dots) projects four rate hikes in 2016, but market expectations see slower momentum given the pace of domestic and global economic and financial conditions. We expect some upward pressure on rates in 2016, particularly in the short end of the yield curve. Regardless of the number of hikes this year, the process of interest rate normalization will likely be gradual and play out over many years.
Mixed economic conditions
The Fed has positioned future rate hikes as “data dependent,” which has evolved in recent months to include global financial conditions and economic data in addition to domestic data. However, in justifying its decision to raise rates in December, the Fed chose to prioritize strength in the U.S. economy over recent global turbulence. We expect U.S. growth to continue on a slow and steady path, which should allow the Fed to tighten policy at a gradual pace. We note, however, that a significant negative macro event outside of the U.S. could complicate this process and lead to some changes to our base-case forecast.
On the domestic front, a myriad of considerations remain. Employment gains are expected to remain a bright spot, but low inflation could present challenges. The Fed has previously expressed confidence that its 2% inflation threshold would be reached in the medium term. We believe lower commodity prices, especially oil, and a strong dollar could challenge the Fed’s medium-term view and make the 2% inflation threshold a challenge.
From a global perspective, the picture is more complex. Conditions in Europe appear to be stabilizing, with growth beginning to emerge in a number of previously contracting economies. However, the low levels of this nascent growth remain an area of concern, and “double-dip” or even “triple-dip” recessions cannot be ruled out. Against this backdrop, aggressive and ongoing monetary stimulus remains key. Conditions in China remain uncertain, and, as we saw last fall, significant weakness could again elevate global concerns to the top of the Fed’s watch list with potential policy ramifications.
A gradual, not mechanical approach
Past Fed tightening cycles were mostly characterized by rate hikes at regularly scheduled Federal Open Market Committee (FOMC) meetings; every meeting was truly in play. Fed Chair Janet Yellen, in her post-FOMC press conference, said there is no set schedule for rate hikes, and it is not the intent of the committee to follow a “mechanical” plan.
The Fed trims its forecasts
Source - RBC Wealth Management, Bloomberg, Federal Reserve; Market data based on Overnight Indexed Swap Rates
We expect the Fed’s forecasts to continue to fall in 2016, gradually shifting toward the market’s expectations.
We feel confident in saying that “gradual” means the Fed will take its time assessing the impact of its recent rate hike. This calls into question the Fed’s forecast for four rate hikes in 2016, especially since current market probabilities place the greatest likelihood for the next rate hike in June. Our two rate-hike expectation is based on continued slow growth and low inflation in the U.S. (coupled with the risk of further U.S. dollar strength), slow global growth, and our belief that the easing bias of most global central banks will push the Fed to be very patient.
Curves ahead: Fed rate hikes drive curve flattening
Source - RBC Wealth Management, Bloomberg; Spread from 2Y to 10Y Treasuries
Each of the past four rate hike cycles has flattened the curve, with 2Y yields rising faster than 10Y yields.
Rates forecasts are too high
It is important for investors to consider where Federal Funds ultimately peak at the end of a tightening cycle. Short- and long-term rates have tended to converge at the peak Fed Funds rate; we believe this should hold true for this cycle too. The Fed’s most recent “dots” have the peak Fed Funds rate at 3.50% in the “long term” which likely means 2018 or beyond; market forecasts, however, have this peak rate at 2% or slightly below. As we move further into 2016, it’s conceivable that Fed forecasts could be revised lower, closer to market projections, if developments in the domestic and global economic/financial data underwhelm market expectations. This would keep the Fed on a slow, gradual path which in the long-term means Fed Funds should peak at a level well below the current “dots” with short- and long-term rates converging near this level.