At the conclusion of last week’s Federal Reserve (Fed) meeting, the Fed released its dot plot, which showed the median forecast among officials is now for three rate hikes in 2022. Moreover, it showed eight rate hikes over the next three years, which would take the fed funds rate to 2.125%. Finally, the Fed stuck with its view that the long-term “terminal’ rate of 2.5% is still appropriate.
“After last week’s Fed meeting, it looks like interest rate hikes are almost surely coming next year,” noted LPL Financial Fixed Income Strategist Lawrence Gillum. “Our main question remains how high and how fast will the Fed hike? The Fed’s ability to hike meaningfully may be limited at this point though so we’re likely staying in a lower rate environment for the foreseeable future.
One of the big risks associated with Fed rate hikes, though, is when the fed funds rate is pushed higher than longer term Treasury yields. In this instance, the yield curve becomes inverted, which means shorter maturity securities out-yield longer maturity securities. Generally, the opposite is true and the yield curve is upward sloping. The slope of the yield curve is an important economic gauge as an inverted yield curve has presaged every recession since the 1970s. So, as seen in the LPL Research Chart of the Day, the Fed’s ability to substantially raise interest rates before yield curve inversion has been trending lower over the last few decades. That is, because the 10-year Treasury yield has been in a secular decline, since the mid-80s really, the Fed’s ability to raise short-term has been impacted.
We think the Fed could start to raise short-term interest rates as early as June 2022 but acknowledge that an earlier timetable is possible. More important, though, is how high the Fed tries to raise interest rates and how quickly it tries to get there. A slow deliberate pace of rate hikes, regardless of when liftoff takes place, will likely lead to a better outcome for the economy, and thus markets, than an overly aggressive one. Certainly the Fed is aware of the risk of hiking interest rates to the point where the yield curve inverts. So, as it stands now, we think the Fed will likely tread lightly after the first few rounds of interest rate hikes next year.
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