Cautious Fed comments suggest US interest rates won’t rise too much
Stocks should continue to see gains through this year, but oil price is a wild card
The Federal Open Market Committee statement released at 2 pm EST stated that “economic conditions will evolve in a manner that will warrant further gradual increases in the federal funds rate,” but noted that “market-based measures of inflation compensation have increased in recent months but remain low.” The market for federal funds futures has already priced in another half-percentage point increase in the overnight rate during the next 12 months.
What would happen if the Federal Reserve acts more aggressively than the market expects, and raises the funds rate by a full percentage point instead? As the chart below shows, there is a nearly straight line relationship between the expected federal funds rate 12 months’ hence and the yield on 5-year inflation-protected Treasury securities, or TIPS. A jump in the TIPS yield during the past two weeks provoked the two-day selloff in equities. Equity markets generally don’t like higher real interest rates. Based on the relationship between federal funds futures and the 5-year TIPS yield, an additional half-percentage point of Fed tightening should raise the TIPS yield by about 30 basis points (or 3/10 of a percentage point).
That’s noticeable, but hardly noxious. In a growing economy 30 bps of additional borrowing costs doesn’t matter too much. The risk lies not in the “real” component of interest rates, but rather on the inflation side. Most of the rise in interest rates in the past six months was a direct response to increase in the price of oil and other raw materials, which are reflected in the inflation component of Treasury yields. Oil is likely to range trade for some time, as higher prices draw additional supply from American shale producers.
So the outlook for US bond yields suggests modest increases, rather than sudden jumps. Equities should eke out further gains in the course of the year. But here’s a caution to investors: The oil price is a wild card in global equity markets, so if you own stocks, make sure to own some that reflect the oil price.