Market Views: Where next for US interest rates?
It promises to be an eventful and unpredictable year for global financial markets. Will monetary policy, especially in the world's largest economy, provide more reason for investors to fret?
Certainly, 2018 has been no easy ride. Several major indexes saw a sharp decline in returns. Both the Dow Jones Industrial Average and S&P 500 shed around 6% last year, while the MSCI Emerging Markets index, plunged by 14.57%.
Towards the end of last year, trade tensions between the US and China also escalated sharply, while President Donald Trump berated officials for keeping monetary policy too tight.
The return to market volatility amid growing concerns about growth prospects, particularly in the second half of last year, prompted the Federal Reserve to move in the direction of soothing frayed investor nerves.
In January, after making a relatively sombre assessment of the US economy, the central bank opted to keep interest rates on hold and dramatically altered its interest rate guidance, indicating it was prepared to be patient before taking its next rate step. It also showed signs it might end its plan to wind down its balance sheet.
Indeed, the Fed itself seemed unsure about what to do next with interest rates given rising economic challenges. Many investors now expect a synchronised global growth slowdown over the next 24 months, and possibly even a mild recession.
Will that stop the Fed in its interest rate tracks, after raising the benchmark rate four times in 2018 to a band of 2.25%-2.5%?
From being utterly certain that the benchmark Fed funds rate would continue to climb higher in 2019, a growing band of experts now believe that rates will be put on pause this year. Indeed, a few investors are also betting that the interest rate could even be cut should economic conditions worsen.
AsianInvestor asked the CIOs of a Chinese lifer and a wealth management firm, along with a multi-asset solutions expert, a rates specialist and market strategist for their views on what could be next for US monetary policy and what that could mean for fixed income investments.
The following extracts have been edited for brevity and clarity.
Benjamin Deng, group chief investment officer
China Pacific Insurance Company
My base-case scenario is the US will stay put on interest rates. But I wouldn’t be surprised if they cut rates if the market data deteriorates. That may be a result of ‘unfavourable progress’ of the trade war. The US was in a mode of “reloading the gun” when it raised interest rates earlier, as it could then have the “munitions” to tackle a worsening economy by lowering interest rates.
In fact, the US economy has never fully recovered [from the global financial crisis]. The unemployment rate is very low, but on the other hand, the job participation rate is very low as well.
There is also a disparity of sectors [growing or otherwise] in the US: information technology is growing fast, but manufacturing is not returning [to previous levels].If the US and China do not have any agreement towards settling the trade war, we are very likely to see the US economy start going down.
Geographically, there is a polarisation as well: you can see San Francisco and California booming, but when you look at the mid-West, or upstate New York, you also see that a lot of cities are just deteriorating. The way I see it, it is taking the US a much longer time to recover.
Tuan Huynh, CIO and head of discretionary portfolio management for emerging markets
Deustsche Wealth Management
We expect the Fed to raise interest rate once (25 bps) this year, likely in the second or third quarter. There are three main reasons. Firstly, wage growth in the US could continue to rise in the first half of this year given the robust labour market. Secondly, oil price may go up again from the current low level, which would support the headline inflation in the US. Thirdly, the financial conditions in the US eased recently with the lower yields and higher stock market. The Fed may consider raising rates again in this environment to save bullets for future economic slowdown/recession.
In fixed income, we favor short-dated investment grade (IG) in the US. In the late cycle environment, we suggest moving up the quality ladder and investing in IG (instead of high yield). We favour short-dated bonds because long-term rates could be more affected by any changes in market environment in late cycle.
We also favor emerging market (EM) USD bonds. We think EM USD bonds would be supported by 1) the resilient EM fundamentals with GDP growth of likely above 5% this year; 2) the Fed could raise rates much slower this year compared to 2018; 3) US dollar strength could be milder this year compared to 2018. We favor both EM USD sovereign and corporate bonds. Within EM corporate bonds, we favour Asian corporate bonds over Latin America due to their lower default rates.
Thomas Poullaouec, head of multi-asset solutions for Asia Pacific
T. Rowe Price
I think the issue right now is not whether the Fed can or cannot hike (or cut) rates based on their dual mandate. The issue is the complacency with which market participants have bought into the idea that the Fed hiking cycle is now over. This is at odds with what the Fed is saying and with what the jobs market is suggesting.
To be fair, muted inflation pressures give the Fed leeway to wait, but as energy prices’ year-on-year effect becomes less supportive later in the year, a rise in inflation associated with the ongoing strength in the job market would definitely support a Fed hike. Given the current level of complacency priced in by market participants, any move from the Fed would definitely be a source of volatility.
Based on historical precedents, one or more hikes could be expected, even if this cycle is projected to be considerably more gradual than past cycles and have a lower than normal end point.
Our current positioning within fixed income favors US investment-grade, inflation-linked bonds (based on valuations) and EM debt assets. For EM debt, yields are attractive relative to fundamentals, supported by a slower Fed path and fading country-specific risks. Many EM currencies have been unduly punished amid idiosyncratic concerns, making valuations more attractive in select areas. We keep our duration risk relatively low and use cash like assets when possible to reduce risk.
Johan Jooste, head of rates
Bank of Singapore
The latest minutes reveal that the possibility of a further hike has not been dismissed totally. So, one more is certainly still possible. The Fed’s approach will, from now on, be different from the traditional approach of being pre-emptive in tightening policy in anticipation of inflationary pressures. Instead, it is looking more to current indicators of price pressure. This makes policy-making more reactive and possibly risky in the event of an inflation surprise.
A decrease [in interest rates] is less likely. The Fed has made further tightening conditional on inflation. It thus follows that much slower economic growth, coupled with unexpectedly weak inflation numbers are the most likely factors that will move the Fed to cut this year.
In our assessment, the market is assigning a slightly higher probability to this outcome than is warranted. The US economy might be growing at a reduced rate, but there are still enough signs of potential prices pressure around to prevent the Fed from cutting this year.
We have a preference for strong credits over sovereign (especially developed markets). We are also quite comfortable to be neutral on duration – not too short because the immediate risk of a rate spike looks quite low.
Dave Lafferty, chief market strategist
Natixis Investment Managers
While on pause for now, our base case is that US growth is decelerating but not stalling. This argues for one more hike by the Fed in the second half of 2019. Two hikes might be possible – September and December – if US growth or inflation began to reaccelerate, but we view this as unlikely.
We are not expecting a rate cut in 2019. A more likely scenario is that the Fed remains on the sidelines for the rest of year if the economy slows more dramatically than we currently expect. While decelerating, we don’t think the economy will stumble badly enough to warrant a rate cut.
For the first time in several years, we are comfortable with investors holding a bit more duration. We think the interim peak in yields occurred last year and with growth globally slowing, we see little upward pressure on either real rates or inflation premiums.
There is a fairly pervasive fear among investors that central banks may “overtighten”, prompting the next recession. In one sense, we’re a bit less pessimistic. Given the problem in Brexit, the Fed has turned sufficiently dovish that forward action (raising rates and/or balance sheet roll-off) is unlikely to bring recession. So we rate the risk of the Fed inducing a recession this year at 10%.
To be clear, there is no doubt that the next recession will occur eventually. We think this is more likely to happen in 2020 or later and we remain in the “slowdown, not recession” camp… for now. Regardless of when the recession hits, the Fed’s tightening to this point will be a handy scapegoat regardless of their actual culpability.
Jolie Ho and Indira Vergis contributed to this story.