market views

Fed Hikes Rates, But What's Their Next Move?

Chris Gaffney | July 1, 2017 5 MIN READ

The Federal Open Market Committee (FOMC) announced a .25% interest rate hike following their meeting in mid-June. They also laid out a plan to shrink the $4.2 trillion portfolio of Treasury bonds and mortgage-backed securities, which has been accumulating since the 2008 financial crisis. Neither was much of a surprise to investors as Fed members had been signaling these moves for several weeks. But the larger question is what comes next?

In the press conference following the June meeting, Janet Yellen suggested that there would be one more interest rate increase in 2017. She pointed to a rebound in economic growth and the stabilization in the unemployment rate as supporting the decision to raise rates.

But many investors are questioning the ability to continue to raise rates with inflation running below the Fed’s stated goal of 2%. The day the FOMC announced their rate increase, the Labor Department reported consumer prices unexpectedly fell in May, which was the second drop in three months. As you can see in the chart below, the personal consumption expenditure (PCE) Inflation rate, the Fed’s preferred gauge of inflation, has been stuck in a very narrow range even though the unemployment rate has fallen to what most consider ‘full employment.’



Data Source: Federal Reserve Bank of Dallas, Trimmed Mean PCE Inflation Rate [PCETRIM12M159SFRBDAL], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/PCETRIM12M159SFRBDAL, June 26, 2017.

When asked about the recent weak inflation readings, Yellen said they appeared to be driven by ‘one-off’ items and she is convinced inflation will rebound: “It’s important not to overreact to a few readings and data on inflation can be noisy.”

Investors will need to keep a close eye on future PCE Inflation reports to see if the recent drop is temporary as Yellen suggests. If prices continue to fall or hold steady below the 2% goal, the Fed will be hard-pressed to continue to raise interest rates. Currently the markets have ‘priced in’ one more rate increase in 2017, so if the odds of another rate increase in 2017 begin to fall, the markets could be forced to adjust. In my opinion, the currency markets would be the first to react with the dollar selling off on the thought of lower U.S. rates. The impact on equity markets would be less clear. Some investors would see continued low rates as a positive for the stock market, but others could see the lack of inflation as a sign that the U.S. economic rebound is slowing. Again, investors will need to continue to watch the PCE Inflation report for direction on the future of prices here in the U.S.

BALANCE SHEET NORMALIZATION: THE NEXT STEP

In addition to the rate increase, Fed members have laid out a plan to reduce their balance sheet later this year. They would begin the process by not reinvesting maturing bond proceeds. For Treasuries, which make up a majority of their bond portfolio, they would hold back about $6 billion per month and increase that figure by another $6 billion at three-month intervals over 12 months until it reached $30 billion per month. Agency debt and mortgage-backed security reinvestments would be reduced by $4 billion per month initially, with an additional $4 billion held back each quarter until reaching $20 billion per month. Therefore the Fed will ultimately reduce the balance sheet a rate of $50 billion a month and continue on this set path until the bond portfolio returns to more normal levels.

In a report released in May, the Kansas City Fed estimated that a $675 billion reduction in the Fed’s balance sheet would equate to a .25% increase in rates. The Fed’s $4.2 trillion bond portfolio is almost $3.5 trillion higher than it was prior to all of their quantitative easing (QE) efforts, so you can see that $675 billion is just a start. The addition of these ‘stealth rate increases’ to the actual rate increases that are already planned could create headwinds for the U.S. economic recovery. Higher interest rates are typically used to slow down an economy, and the U.S. economy certainly doesn’t look like it needs any help in slowing down.

YIELD CURVE FLATTENING—AN OMINOUS SIGN?

I frequently get to speak to investors and a recent topic has been the dichotomy presented between the U.S. treasury yield curve and the FOMC members. The Fed believes the U.S. economic recovery is gaining steam with many of the members increasing their forecast of U.S. growth in the latest set of quarterly economic forecasts. Investors in the U.S. Treasury market, however, don’t seem to share the Fed’s optimistic outlook as the spread between the yield on the 2-year and 10-year treasury bonds has continued to narrow.

A robust economy typically supports a steep yield curve, with the yield on longer term treasuries substantially higher than the yield on short term securities. A flat or negative yield curve, on the other hand can be a harbinger of a recession. The graph below shows the difference between the yield on the 10-year and 2-year treasuries which is an indication of the slope of the yield curve. As illustrated in the graph below, every U.S. recession over the past 35 years has been preceded by a negative yield curve.



Data Source: Federal Reserve Bank of St. Louis, 10-Year Treasury Constant Maturity Minus 2-Year Treasury Constant Maturity [T10Y2Y], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/T10Y2Y, June 25, 2017.

Currently we still have a positive sloped yield curve, but the curve has been flattening which is not a positive sign for the U.S. economy. The equity markets continue to hit new records, while investors in the bond market look convinced that the U.S. economy will recover at a glacial pace (if at all).

By laying out a clearly defined plan, the members of the FOMC have tried to make sure the normalization of interest rates and the reduction of the Fed’s balance sheet will occur with minimal market disruption. “The plan is one that is consciously intended to avoid creating market strains and to allow the market to adjust to a very gradual and predictable plan,” Ms. Yellen said at a news conference in June. But in spite of all of their efforts to make sure Fed policy is clearly communicated to the markets, questions remain which could lead to unexpected volatility.


Chris Gaffney
Chris Gaffney
President, EverBank World Markets
Chuck Butler
Chris Gaffney
President, EverBank World Markets
With over 30 years of experience in the financial services and global markets industries, Chris is often called upon by the national media for insights and commentary on the news and trends shaping our world economies and opportunities.

All statements, comments and opinions expressed are solely those of the writer or speaker and are not the statements, comments or opinions of EverBank or of any of its affiliates, and are subject to change without notice. Due to the rapidly changing nature of currency and commodities markets, any statement, comment, or opinion may quickly become outdated. This is not a solicitation for the purchase or sale of any securities or options on securities or for the purchase or sale of a currency or any precious metal, and it does not constitute a recommendation to you or to any specific person of any particular action. EverBank, its officers and employees do not provide investment or other types of advice. All factual information has been obtained from sources that the writer or speaker believed to be reliable, but the accuracy, completeness, and interpretation of the factual information is not guaranteed and has not been independently verified. Not all products are right for everyone. You should conduct your own research and/or consult your advisor before making any purchases.