For the first time in nearly a decade, last week the Federal Reserve raised its target for the federal funds rate. Despite market pundits continually criticizing the Fed for its lack of clear and transparent communication, this move was well telegraphed. Late Wednesday afternoon we listened to a Citigroup webcast that featured traders from each of their trading desks, ranging from commodities to bonds to stocks. Every trader had the same message: “This move was fully baked in and there’s been no change since the announcement.” So, what now? From a bond perspective, there are a few important points to remember:
- The Fed only controls the fed funds rate, while the market controls longer-term rates. This is highlighted by the fall in longer-term bond yields on Thursday and Friday of last week, as commodities resumed their sell-off and investors questioned the outlook for growth and inflation. In short, just because the Fed tightened doesn’t mean all bonds fall in price.
- As we mentioned last week, the dot plot, which represents FOMC members’ expectations for the future path of interest rates, was a primary focus, and it generally met market expectations. The dots showed that the range of future rate expectations converged around the prior median. For example, the distribution of expected policy rates at the end of 2016 narrowed by 175 basis points, and the trimmed mean fell by 20 basis points. This reduction was driven by a lowering of the 8 most hawkish (or highest) expectations.
- Low and slow is the likely path, and what interest rates do from here will be dictated by incoming economic data. The Fed is predicting 4 additional hikes in 2016, but the market is predicting 2. How these predictions play out and ultimately converge will likely be the major driver of rates next year.
Sources: Bloomberg, RBC