By Gregory S. Kaplan, CFA
- Fed may delay next hike after soft inflation readings; hurricanes
- Key for investors is not timing of hikes but where rate winds up
- “Barbell” portfolio strategy indicated as yield curve flattens
In a note to clients earlier this year, we made the case that interest rates would move modestly higher in 2017. Our expectations have proven correct on the short end of the yield curve, although yields on the long end have been lower year-to-date. Bonds have performed well as the market lowered the odds of meaningful fiscal stimulus, a key driver in expectations for faster GDP growth and higher rates.
Nevertheless, the economy has remained stable and growth shows signs of accelerating. With inflation expected to edge higher, unemployment heading even lower, and tax cuts still on the table, we are expecting yields across the curve to edge higher as well.
Although the market is now pricing in a greater than 50% probability of another interest rate increase in December, we think the Fed is more likely to delay due to continued softness in inflation and disruption in the economic data from the two hurricanes that made landfall in August and September. Risks to this forecast lie in the recent hawkish shift of the FOMC and the easing of financial conditions in spite of Fed rate hikes (see chart).
The exact timing of the next increase is less important to financial markets than the Fed’s forecast for the Fed Funds rate at the end of this hiking cycle. This “terminal rate,” sometimes called the neutral rate, has migrated lower throughout the current expansion and reset another quarter-point lower, to 2.75%, at the FOMC meeting in September (see chart). The neutral rate is the Fed Funds rate that is neither stimulative nor restrictive to economic growth with stable inflation.
What does this mean for investors? Even though the Fed is expected to continue tightening monetary policy and raising short-term rates, longer-term rates are likely to be contained. This suggests that a barbell strategy – investing in long and short duration bonds but underweighting intermediate duration issues – is still preferred so as to take advantage of the flattening yield curve. We also may see longer duration assets surprise with continued solid performance.
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