Possible Federal Reserve Outcomes - Shift Rates or Get Off The Pot

This week the Federal Reserve will hold their scheduled policy meeting, and will have to make a decision about whether or not to lift the fed funds rate off the zero bound. For context, the Fed has effectively held the fed funds rate at zero since December 2008. Currently, the U.S. economy is growing at a moderate pace, labor markets are tightening (though slack remains), inflation is stubbornly low and global economic growth is decelerating driven by lower economic output from China and the emerging market economies. Given both the economic backdrop and conflicting messages from committee members, the Fed decision on rates is reported to be a coin flip, though mathematical interpretations based on short term fed funds futures contracts place the odds of a rate hike at less than 30%. The following are two potential outcomes of next week’s policy decision:

The first scenario is the Fed continues with a zero bound policy because global growth is decelerating and the U.S. dollar is strengthening relative to other currencies, which has tightened financial conditions. Further dollar strength could lower the Fed outlook on inflation expectations. If this scenario comes true, there is a high likelihood that Two-year Treasuries would rally. Since the end of 2013, Two-year Treasury rates have sold off about 50bps (see chart below) in anticipation of tighter monetary policy, but if the Fed continues to push out the first hike, lower front-end rates and a steeper yield curve could occur. 

The second scenario is the Fed lifts rates by 25bps for the exact opposite reasons from scenario one – the U.S. economic expansion remains intact in the face of slowing global growth, inflation expectations are stable and financial conditions remain accommodative by historical standards. If this scenario comes true, the impact on U.S. Treasury rates would likely be somewhat muted in the mid-term as much of the rate hike has already been priced in. The secondary and tertiary impacts from a higher fed funds rate could be a flatter yield curve because long-term expectations for growth and inflation fall as the U.S. interest rate and business cycles mature. 

Whatever happens on Thursday, the overall impact on bond investors will likely be muted. But, after almost seven years of extraordinary monetary policy, the bond market is anxiously waiting for the Federal Reserve to shift its policy stance or get off the pot.

Source: Bloomberg and SNWAM Research