Last Thursday, the Federal Reserve lifted its target rate with another 25 basis points. Not like anybody cared, as the rate hike was signaled well in advance. More importantly, the Fed repeated its willingness to hike another three times next year, while markets continue to refuse to believe it. This could lead to increased bond volatility.
In her final FOMC, Janet Yellen raised the Fed target rate for the third time this year. At the same time, an updated version of the ‘dot plot’ was released. The dot plot represents the interest rate level FOMC-members believe is appropriate given the expected economic circumstances. The average of the dots ‘reveals’ the number of rate hikes the Fed intends to push through. As can be derived from the dot plot shown above, that number for 2018 is three.
Investors, however, are not buying it. Even after the publication of the updated dot plot, the market expects barely two increases. According to some Fed-watchers, this has to do with the fact that the Fed upped its GDP growth forecast and lowered its unemployment rate forecast, without changing the inflation outlook. In other words, even though the economy is doing better than expected, this does not provide more upward pressure on inflation. Perfect conditions for the Fed to take it easy, right?
Lack of credibility
While it hard to fully dismiss this explanation currently, I believe central bank credibility is at work here. The graph below shows the Fed target rate plotted against the expected or forward rate implied by the Fed futures. The graph reveals that, for years, markets expected the Fed to start hiking rates, but also that this never happened in practice. Assuming investors have moved up the learning curve just a bit, would help explain why investors are unwilling to believe the Fed’s rate outlook.
Unfortunately, I think investors could be wrong this time as well, even as the credibility of central banks is certainly under pressure. This year the Fed has fully committed to its dot plot by hiking three times. Despite this, the target rate, currently at 1.50% (upper bound), remains extremely low. With GDP growth expected to reach 2.5% and the unemployment rate to fall to 3.9% (which is way below NAIRU or the non-accelerating inflation rate of unemployment) the Fed will be inclined to lift its target rate to at least the neutral level. The discussion on what that rate is exactly drags on. But let’s set it at 2.5%, which is the number pops up most frequently. That’s still four 0.25% hikes away. In addition, if economic expectations materialize, the Fed will be inclined to raise rates even further. This is because the probability of inflation climbing significantly above the desired 2% threshold will be greater than the probability of a relapse of inflation numbers. This is reason for the Fed to expect another two rates hikes in 2019. Which, by the way is one more (rounded) than in the previous dot plot.
Hawks to succeed doves
Next to economic strength, the upcoming changes in the FOMC voting members will also add to the Fed’s willingness to hike rates. For example, both Evans and Kashkari, from the Chicago Fed and Minneapolis Fed respectively, voted against the latest rate hike. But both gentlemen will be replaced by hawks out of Cleveland and San Francisco next year. As the chart from Barclays below shows, the FOMC will become more hawkish, even as some vacancies are yet to be filled.
To sum up, market looks a bit too complacent concerning future US monetary policy. When investors start to realize that the Fed will raise another three times in 2018 they will have to adjust their views, likely resulting in higher bond yields. Add to this, the fact that pace of the balance sheet reduction will increase over time, and we are up for some exciting times in bond markets.