On Wednesday, the Federal Open Market Committee concluded its June meeting. There was a lot to digest: Another 25bp rate hike, clearer signals about two more hikes in 2018, a new set of economic projections, and Fed Chairman Powell’s press conference. Here are some of our team’s initial thoughts.
The rate hike was no surprise
This rate hike was widely expected. Before the meeting, most investors also foresaw another hike in September, and were split on another in December. Now, expectations will likely solidify around two more hikes this year.
To state the obvious, market prices are based on expectations. We are less concerned about additional Fed rate hikes if they are expected and telegraphed. We are more focused on the Fed’s “reaction function”—in other words, on the events and trends that might disrupt the Fed’s current pattern. What are the intervening events that might interrupt the Fed’s plans—causing them to either halt its hikes or accelerate them?
The “dot plot” shows little change
The Fed’s reaction function is a big reason why the new Summary of Economic Projections (SEP) is worth some additional scrutiny. This report includes the infamous "dot plot," a chart that depicts each FOMC member's view on where the Fed's rate target should be based on his or her economic outlook.
The media often focuses on the median viewpoint among FOMC members, which can shroud the Fed’s broader view. In this report, the median FOMC view on the year-end rate moved from 2.125% (implying three total hikes this year) to 2.375% (implying four). But the shift was due to a single member moving their forecast—all other members’ views were unchanged.
The Fed seems comfortable with inflation trends
Lately, inflation indicators have nudged higher, but Powell did not signal more aggressive hikes to stem inflation. He suggested that the uptick is likely due to transitory factors from 2017 rebounding, and stated that “if we thought inflation would take off, we would be showing higher rates.” The lack of major movement in the dot plot suggests that the committee largely agrees with this view.
Along with consistency, there’s uncertainty
Despite the consistency in messaging this year, there are clearly events that could derail the Fed’s current path. He largely deflected questions on how a bigger deficit, rising corporate leverage or a potential trade war might impact the economy. At the same time, he stated that the Fed was likely nearing a “neutral” rate that is neither stimulating nor constricting the economy.
We need to acknowledge that the Fed may not be able to stay “neutral” and may have to speed up or slow down its trajectory if events unfold in an unexpected way. When you consider that monetary policy is also near neutral, it all adds up to a narrow margin of error for the Fed.
Conclusion: Don’t play the expectations game
Bond investors need to respect that uncertainty may impact interest rates and economic growth. Rather than placing bets on uncertain economic outcomes, we prefer to focus on fundamental credit analysis and remain flexible. Flexible investors can watch for moments when a big consensus swing opens up an attractive entry point for a solid investment.
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