Summer rerun: Fed remains in tightening mode with second rate hike of 2018

A perspective from E*TRADE Capital Management, LLC

06/13/18
“Wow, that was a surprise”—said virtually no one on Wednesday after the Federal Reserve increased the federal funds target rate by 25 basis points (1 bp = one one-hundredth of a percent) to a range of 1.75%–2.00%, the second such rate hike in 2018 and the first since March . The Fed has now lifted short-term interest rates seven times since late 2015.
US benchmark Treasury bond yields, June 12, 2018

Source: The US Department of the Treasury

The Federal Reserve is systematically moving toward rate normalization after an extended period of quantitative easing that brought the benchmark federal funds rate as low as 0.0–0.25% on the heels of the 2008 financial crisis. In making its decision this week, the Federal Open Markets Committee (FOMC)—the Fed’s policy-making arm­—cited continued improvement in the US economy and a strong labor market.

The decision to tighten monetary policy came as little surprise to most market participants. The CME FedWatch Tool, which calculates unconditional probabilities of FOMC meeting outcomes, pegged the chances of a 0.25% hike at approximately 91% as of last week.1 At its Wednesday meeting, FOMC members signaled that two additional rate hikes are likely in 2018. 

More rate hikes could be on the way in 2019

Judging from comments made by Federal Reserve Chairman Jerome Powell the last time the Fed raised the federal funds rate, investors should anticipate more rate hikes in 2019 if the US economy remains in high gear and inflation doesn’t lag the Fed’s target rate of 2%.

“We need to make sure that inflation expectations are anchored at two percent,” said Powell in March. “So we’re trying to take that middle ground, and the Committee continues to believe that the middle ground consists of further gradual increases in the federal funds rate as long as the economy is broadly on this path.”3

What could this mean for the markets?

Although past rate hikes have at times led to market volatility, the Fed’s most recent move was well-telegraphed, which market observers expect may help keep a lid on near-term market turbulence related to monetary policy.

However, the Fed’s hawkish stance could have ramifications for the US Treasury yield curve, which has flattened considerably over the past year as the differential between short- and long-term yields has narrowed. As of June 8, the spread between 2- and 10-year Treasury yields was 0.43%, compared with 0.86% last year.

Market observers watch the shape of the Treasury yield curve because an inverted curve could signal recession. A flattening yield curve is not the same as an inverted curve, however, and investors have many choices for positioning their portfolios in a rising rate environment.

Having lifted short-term rates, the onus is now on the Fed to strike a balance between containing inflation and keeping monetary policy accommodative enough to support economic growth.

The fed funds rate since 2008, June 13, 2018

Source: The US Department of the Treasury

More yield opportunities?

Since 2008, quantitative easing has lowered lending rates across North America and created a dearth of compelling yield opportunities. The hunt for yield has elevated some investors’ appetite for risk, leading many to consider asset classes such as high-yield bonds and emerging market debt.

Rising short-term rates could allow investors to find yield in more conservative asset classes like Treasury bills and commercial paper. While these aren’t exactly the bedrocks of a growth strategy, they can help cushion a portfolio against periodic market volatility and provide ancillary income potential. If interest rates continue to rise, investors may wish to assess their current risk allocations and recalibrate as needed.

Focus on your plan

Concerned about higher rates? There are opportunities to consider. But portfolio adjustments should be made within the context of one’s individual goals, risk tolerance, and time horizon. Take on only the level of risk that makes you comfortable. As always, we believe investors can benefit from a well-diversified portfolio of domestic and international equities, fixed income securities, and cash.

Despite Wednesday’s decision, the fed funds rate is still low by historical norms. Bottom line: The Fed is likely to remain in tightening mode for the foreseeable future. The FOMC will hold another four meetings this year—all of which involve press conferences—that could very well net more increases in the federal funds rate. 

At E*TRADE, we’re committed to helping you make sense of the markets. If you have questions or would like to talk about your portfolio, please don’t hesitate to visit us at etrade.com to chat with us online, send us an email, or call us if you like at 800-ETRADE-1 (800-387-2331). We’re always ready to help.

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1. CME Group FedWatch Tool. June 7, 2018. http://www.cmegroup.com/trading/interest-rates/countdown-to-fomc.html

2. US Federal Reserve System. “Chairman's FOMC Press Conference Projections Materials,” March 21, 2018. https://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20180321.pdf

3. US Federal Reserve System. “Transcript of Chairman Powell’s Press Conference,” March 21, 2018. https://www.federalreserve.gov/mediacenter/files/FOMCpresconf20180321.pdf