Federal Reserve increases target funds rate while upgrading 2018 and 2019 economic growth expectations
Date: September 26, 2018
Today, the U.S. Federal Reserve (Fed) announced a widely expected increase of 0.25 percent in the benchmark funds rate, which moves the target rate to a range of 2 percent to 2.25 percent. The median estimate of Federal Open Market Committee (FOMC) members continues to point to one more rate hike in 2018, with three additional rate increases expected in 2019. The median estimate for the longer-term target rate nudged higher from 2.875 percent to 3 percent. Economic growth projections for 2018 and 2019 were upgraded while inflation expectations for 2019 were trimmed slightly.
As with recent press conferences, Federal Reserve Chairman Jerome Powell struck a constructive tone, reiterating that the U.S. economy remains strong. The collective tone of economic and interest rate projections, the overall statement and the ensuing press conference were largely consistent with investor expectations. Capital markets reacted modestly after the announcement, with U.S. Treasury yields down slightly and the S&P 500 trading off of the day’s highest levels and closing modestly lower. We continue to anticipate gradual upward pressure on government bond yields as capital markets increasingly price in the Fed’s projected rate path for 2018-2019.
Market expectations for future interest rates continue to lag below the Fed’s dot plot path
In recent weeks, market expectations for future rate increases have risen materially, driving short- and long-term government bond yields higher. However, expectations still lag median Fed expectations as gauged by their median "dot plot,” a gauge of FOMC members’ expectations for the target funds rate in coming years. By reiterating their 2018, 2019 and 2020 expectations via no change in median dots, the Fed has further solidified their near-term outlook for further rate hikes. Fed dots imply an increase of 1 percent (four hikes) to the benchmark funds rate between now and year-end 2019 versus current market expectations of only 0.67 percent (2.7 hikes). As the market increasingly comes to terms with the Fed’s likely path, we expect continued modest upward pressure on both short- and long-term government bond yields.
Economic projects indicate continued economic strength and a tight jobs market
The Fed's economic projections included increases to 2018 real gross domestic product (GDP) expectations to 3.1 percent from 2.8 percent, and nudged 2019 estimates up to 2.5 percent from 2.4 percent. Expectations for the unemployment rate in 2018 were increased to 3.7 percent from 3.6 percent. Core inflation expectations ticked lower to 2 percent from 2.1 percent for 2019, which is in line with the Fed’s target. The continued robust expectations around growth and the jobs market, along with inflation expectations in line to slightly above the inflation target, are supportive of the Fed continuing to increase rates at a steady, gradual pace.
The Fed’s statement and Chairman Powell’s press conference comments support further rate increases
As widely expected, the Fed’s statement removed the language that had stated policy remains accommodative. Chairman Powell addressed this change early and directly in the press conference, stating it represents an acknowledgment that policy is proceeding in line with expectations. Combined with the constructive tone during the press conference, we see no evidence to question the near-term (2018-2019) rate path as laid out by the Fed’s median dot plot. This remains in the context that any material changes to the economic landscape could, of course, impact the path of growth, inflation, employment and thus, the path of the Fed’s policy rate.
We continue to expect modestly higher bond yields and recommend shortening portfolio duration
Our view remains unchanged and we continue to believe bond yields are likely to move modestly higher this year and into 2019, supported by continued gradual rate increases, strong growth, inflation near the Fed’s target and higher U.S. Treasury supply. We continue to believe the Fed will increase rates a fourth time in 2018 (at the December meeting) and their median 2019 estimate of three rate increases is a reasonable base case. As markets increasingly price in this likelihood, government bond yields are likely to rise. We continue to believe the risk/reward of Treasuries relative to investment grade corporate credit is balanced since, for the time being, the strong economy supports historically high credit valuations. As borrowing costs increase, we will continue to assess the impact on corporate fundamentals and valuations. We continue to advocate for below-benchmark duration exposure due to our expectation for higher yields, combined with the flat yield curve, which creates minimal opportunity cost for remaining in shorter-duration exposures.
Potential risks to our outlook
Domestic economic growth appears to be strong and, in our view, the United States remains “the best house in a global neighborhood.” However, risks remain, including trade negotiations that, to date, have been more newsworthy than market worthy but may yet escalate to levels that could result in a capital market response. In addition, moderating economic growth outside the United States could become a drag on strong U.S. growth. In this case, the Fed’s projected path of rate increases could be called into question.
As we enter into an event-filled fourth quarter, we will keep you informed of our views. Please do not hesitate to contact us for insights related to your unique circumstances or if we can be of assistance.