What The Fed’s Latest Rate Bump Means For Investors

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June 14, 2018 6:13am NYSE:IEF

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From Invesco: The Federal Reserve (Fed) hiked rates by 0.25% for the second time this year, lifting the range for the federal funds rate to 1.75% to 2.00%. The statement that accompanied the meeting reflected a strengthening of the economy. 

The Fed also increased the rate of interest on excess reserves by 0.20% with the intent of moving the effective federal funds rate closer to the middle of the band.

The Fed’s summary of economic projections (SEP) showed improvement in its forecast of growth and a lower expected unemployment rate. The most surprising change in the SEP was a drop in the Fed’s forecasted unemployment rate without a change in its long-term estimate of the non-inflationary rate of unemployment. This suggests the Fed views the economy as having less employment slack compared to its previous meeting. In addition, the median SEP now forecasts four interest rate hikes in 2018 (versus three previously). We do not view this as a significant change. Although the median interest rate forecast among Federal Open Market Committee members (“dot plot”) did shift up, on balance only one individual raised his or her forecast. Moreover, the additional hike forecasted for 2018 was pulled forward from 2020. In other words, the individual members maintained their expectation for the level of rates in 2020 at 3.4%.1 The net outcome was perceived as somewhat hawkish by the market, especially due to this change in the “dot plot.”

The Fed’s statement continued to express that economic conditions will likely warrant “only gradual increases in the federal funds rate.” There was no mention of the recent tightening in emerging market financial conditions. We continue to believe that the Fed will act somewhat cautiously (due to low prevailing levels of inflation) despite strong growth.

Yesterday’s inflation data, for example, pointed to a more moderate level overall. Although the year-over-year core rate increased by 2.2%, the three-month annualized rate is now below 1.8% — less than the Fed’s 2% target.2 In particular, the three-month annualized rate of change of the “sticky” core consumer price index (CPI), as measured by the Atlanta Federal Reserve Bank, fell from 2.9% to 2.3% between February and May.2 If this moderation in “sticky” core CPI proves to be persistent (as we expect), overall core CPI readings should begin to cool in the second half of this year and flexible core CPI readings should revert to lower historical levels.

One announcement made by US Federal Reserve Chair Jay Powell at the press conference was the Fed would begin having press conferences after every meeting starting in January. He cautioned that the change was an attempt to increase the level of communication and that it did not infer any change in the speed in which the Fed would adjust monetary policy.

Based on our moderating inflation outlook, we expect the Fed to hike three times this year. We believe the lower levels of inflation that we are likely to experience in the third and fourth quarters, coupled with gradually tightening financial conditions will lead the Fed to pause its hiking cycle to gauge the likelihood of future inflation pressures. In our view, this pause could drive the US yield curve to steepen and the US dollar to soften.

1 Source: Board of Governors of the Federal Reserve System, June 13, 2018.

2 Source: US Bureau of Labor Statistics, June 12, 2018.

Important information

A basis point is one hundredth of a percentage point.

The consumer price index (CPI) measures change in consumer prices as determined by the US Bureau of Labor Statistics. Core CPI excludes food and energy prices.

The federal funds rate is the rate at which banks lend balances to each other overnight.

The yield curve plots interest rates, at a set point in time, of bonds having equal credit quality but differing maturity dates to project future interest rate changes and economic activity. A flat yield curve is one in which there is little difference in the yields for short-term and long-term bonds of the same credit quality. In a normal yield curve, longer-term bonds have a higher yield.

The iShares Barclays 7-10 Year Trasry Bnd Fd (IEF) was unchanged in premarket trading Thursday. Year-to-date, IEF has declined -3.27%, versus a 4.60% rise in the benchmark S&P 500 index during the same period.

IEF currently has an ETF Daily News SMART Grade of B (Buy), and is ranked #10 of 28 ETFs in the Government Bonds ETFs category.

This article is brought to you courtesy of Invesco.

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