Market Views: How much will the Fed hike rates this year?

New Federal Reserve chairman Jerome Powell presided over his first Federal Open Market Committee (FOMC) meeting on March 20 and 21, confirming another 25 basis point increase in the Federal funds rate—the sixth since December 2015.

The widely expected hike lifted the benchmark interest rate range from 1.25%-1.50% to 1.50%-1.75%, driven by expected improvements in labour market conditions and economic growth.

With growing confidence in the US economy from the Fed, expectations of rate hikes have hovered between three and four for 2018. This week, we asked economists, currency specialists, and investment strategists the following:

How many rate hikes do you expect the US Federal Reserve to conduct this year?

Below are their responses, including thoughts on how such changes could affect Asian assets and investors.

Daniel Morris, senior economist

BNP Paribas Asset Management

We anticipate four hikes from the Fed this year. Inflation is normalising and the US economy will be receiving a significant fiscal boost this year between the tax cuts and the debt ceiling deal. With spare capacity very low and growth expectations rising, the Fed will need to tighten monetary policy further than originally expected in order to forestall a bigger increase in inflation.

Equities should benefit the most from modestly higher inflation as corporate profits rise but the Fed will not hike so much that the US economy will decelerate. Rate sensitive sectors, however, such as utilities, would likely underperform. Fixed income will be challenged by rising rates, and corporate bond spreads could rise given that the US economy is relatively late in its economic cycle.

Asian equities should benefit from rising US demand, but the weakening US dollar will temper some of the gains for Asian exporters. Conversely, holders of US dollar emerging market debt will likely suffer as longer term interest rates rise.

In this environment, we prefer local currency emerging market debt, and domestically focused and service sector oriented emerging market equity sectors.

Dwyfor Evans, managing director and head of Apac macro strategy

State Street Global Markets

Although the Fed has maintained its three hike forecast for 2018, the adjustments to 2019 and 2020 rate forecasts suggest that caution about inflation trends in the late-[former Fed chair Janet] Yellen era have dissipated given references to the below long-run equilibrium unemployment rate. The message seems to be that the Fed is aware that it needs to get policy onto a much less accommodative footing, particularly as there been no discernible tightening in overall monetary conditions. 

Emerging markets are interesting here for a number of reasons. The US dollar is unusually disconnected from short-rate differentials and persistent concerns on yield flattening plays out favorably for emerging market currencies, where we see potential for a rebound.

The Japanese yen would also be attractive here on valuations, which remain extremely favorable. Emerging market local currency bonds are also back in favour for two reasons: first, a gradualist approach to US rate hikes indicates only a slow relative rates story with emerging markets and capital outflows from these markets should be limited as a consequence. Second, it implies that emerging market central banks do not necessarily need to hike in response to the US, so with inflation levels low in the former, emerging market bonds still look interesting here.

Asian emerging market bonds and foreign exchange could get some respite from the Fed decision, and the continued weakness of the US dollar implies investors need not necessarily engage in active currency hedging of their regional emerging market positions.

Oliver Jones, markets economist

Capital Economics

We think that the Fed will raise rates four times this year (including at this week’s FOMC meeting on March 21). This is a little more than appears to be discounted in markets at present, and primarily reflects our view that the tightness of the labour market will put more upward pressure on US core inflation this year. The past weakening of the dollar is also likely to continue to drive up import prices in the US.

So far in the Fed’s tightening cycle, Asian assets have generally performed well despite higher interest rates in the US. Asian equities surged last year and currencies strengthened, despite three rate hikes from the Fed. With this in mind, the Fed stepping up the pace of its tightening cycle this year does not automatically mean that Asian assets will suffer.

While we don’t expect a repeat of last year’s significant gains in 2018, this also reflects the prospect of slower economic growth in China and the prospect of greater protectionism.

However, we suspect that Fed tightening will eventually have a greater impact on Asian assets further ahead, once it begins to take a toll on growth in the US economy. We don’t think that this will happen for a while yet, perhaps not until the second half of 2019 once the recent fiscal boost starts to fade.

But if growth in the US does start to slow, then the US stock market would probably fall sharply again. As the sell-off in global equities in early February demonstrated, a correction in the US would probably cause Asian stock markets to slump across the board too.

Although Asian equities might therefore prove vulnerable, local currency sovereign bonds are probably much less exposed to Fed tightening. In our view, few Asian central banks are likely to follow the Fed in raising interest rates. Indeed, we think that policy will actually be loosened in China this year in response to its economy losing momentum. This would probably see local currency bond yields in China fall this year, even as those in the US rise.

David Kohl, head currency research

Julius Baer

New Fed chairman Jerome Powell sounded somewhat more hawkish than expected at last week’s semi-annual monetary policy report to Congress. This has an impact on what to expect for interest rates and Treasuries for the remainder of the year.

Together with robust economic growth, Powell’s most recent report points to four instead of just three rate hikes this year. He stressed in front of Congress that the Fed intends to stick to the gradual path of rate increases. Hence hikes in excess of the usual 25 basis points remain unlikely also in 2018.

But the solid growth outlook for the US, which with the help of fiscal policy will to continue well into 2019, will motivate the Fed to hike interest rates four times this year, more than its most recent median projection suggests. The Federal Open Market Committee (FOMC) will most likely shift its projection upwards at its next meeting on 20-21 March (Editor: the Fed did so at the meeting, noting the economy had been strengthening).

We forecast four rate hikes in 2018, which creates more permanent upward pressure on 10-year US Treasury yields. With rate hikes at the March, June, September and December meetings by 25 basis points each, long-term rates will receive more permanent upward pressure in 2018. 

The ongoing shrinking of the Fed’s balance sheet and plenty of issuance should drive up the compensation investors demand for holding longer-term bonds instead of rolling short-term issues, resulting in levels more in line with history for this demanded term premium. We increase our end-of-2018 10-year Treasury yields forecast to 2.95% from 2.75% expected earlier. Our shorter-term 10-year yield projection at around 3% remains unchanged.