Market Comment – Navigating the path to higher US interest rates

News item -

The US Federal Reserve’s slow and gradual path back to more normal interest rates is expected to continue. That is the message from Fed Chair Jerome Powell’s speech at the annual Jackson Hole Symposium, held every August in Wyoming.

Mary Pieterse-Bloem, ABN AMRO Global Head of Fixed Income, sees the management of expectations and a cautious approach as the signature elements in Powell’s remarks. "The Fed is negotiating a narrow path," she notes, "between doing too much or too little." In fact, Powell noted in his speech that Fed policymakers are always seeking to avoid moving too fast when hiking rates during periods when the economy is expanding, thus shutting down the expansion, versus moving too slowly and risking that the economy destabilizes and overheats.

Given the importance of finding the middle ground, Pieterse-Bloem says that "the Fed will continue to play it safe, looking at a range of real indicators for signs of inflation expectations." These indicators include inflation breakeven rates, the University of Michigan survey of consumer sentiment and other data. "So far,”" says Pieterse-Bloem, "most of these indicators are fairly stable to slightly higher, which supports the Fed’s course of gradual rate hikes." 

Overall, the tone of Powell's speech was positive for the US economy. The Fed Chief noted that the US economy is strong, inflation is near the Fed's 2% objective and most people who want a job are finding one. 

What do we expect?

ABN AMRO expects four more rate hikes by the Fed through to the end of 2019. "We actually expect that the Fed will pause - and take a wait-and-see approach - once they are closer to their own projection of the neutral (neither accommodative nor restrictive) rate of 2.9%." This pause may prevent the Fed following through on its projection of six more rate hikes. 

ABN AMRO's forecast for four US rate hikes between now and year-end 2019 is below consensus estimates. "Most economists now expect the Fed to hike five more times by the end of next year," notes Pieterse-Bloem. Market sentiment is more uncertain regarding future hikes. While the market's reaction to Powell's remarks was muted, and a hike in September is almost fully priced-in, Pieterse-Bloem notes that there is less market conviction in later hikes, mostly due to trade war fears. 

While the Fed's path to higher rates is expected to remain slow and gradual, European rates remain stagnant and at rock bottom. "The European Central Bank is behind the Fed in raising rates," says Pieterse-Bloem.  "We do not believe that this is going to happen before December 2019. Even so, the normalisation of interest rates makes for a challenging environment for bonds. ABN AMRO therefore has a negative view on this asset class." 

For more information on ABN AMRO's insight into the Jackson Hole Symposium, read the view from ABN AMRO'  US economist, Bill Diviney, "Fed Watch: Focus on inflation expectations, rather than the NAIRU."