US economy healthy but international developments will drive decisions

Lisa Hornby, Fixed Income fund manager based in Schroders’ New York office comments on the US Federal Reserve decision to hold rates

The number of hours spent analysing today’s FOMC rate decision must have set some kind of record. Ultimately, the Federal Reserve decided to leave the Federal Funds rate unchanged at 0.25%, citing recent global developments and their potential impact on inflation.

The FOMC also published an update to their infamous “dot plot”, that is each member’s individual projections of where the Fed Funds rate will be for the foreseeable future. The median rate expectation for year-end 2015 through 2017 moved down by approximately one hike per year, with the biggest surprise being that one FOMC member sees the Fed cutting policy rates to below zero and leaving them there until the end of 2016.

The FOMC now expects rates to be at 0.375% at year-end, 1.375% by the end of 2016 and 2.625% by the end of 2017. These forecasted policy changes were done in the context of growth expectations being revised higher for the year and unemployment rate expectations being revised lower. Headline inflation expectations were revised down for the foreseeable future.

The market reaction immediately following the statement was relatively muted. Initially, equity markets moved modestly higher, while 10-year Treasury yields fell towards 2.2% and front end Treasury bonds outperformed longer term Treasury bonds.

The Federal Funds market is now pricing in a 25% chance of a rate hike at the October 28th meeting. Going into the statement, the market was pricing in a 32% probability of a rate increase in September, as well as an extremely gradual and atypical hiking cycle, with just under three hikes priced into the market through December 2016.

To put that into context, over the past three hiking cycles, the Fed has averaged approximately 17 basis points of rate increases per month (or one hike every Fed meeting). However, even with the Fed’s revised projections, the market is still reflecting a much more benign outlook for policy rates than both the Fed and we are expecting.

All in all, the Fed’s economic outlook remains relatively stable and positive. However, it is clear that international developments will dominate Fed policy in the near-term.


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