Cameron's Blog - Federal Funds Hike

Federal Funds Hike

This article first appeared in the Reading University Investment Society’s April edition on April 16th, 2017.

Last month, the Federal Reserve raised the short-term interest rate target range by 0.25%, to a range of 0.75% to 1%. This is in line with the central bank’s “slow and steady” approach to rate increases after a decade of historically low interest rates, and is the third such rate increase since June of 2006. The Federal Reserve has further signaled its intentions to complete at least two more quarter-point increases during 2017, with the median projection among Fed officials sitting at 1.4% by year-end. This reflects a positive outlook for the US economy, as wage and job growth continue to display robustness in the face of a volatile global market place. But how likely are rates to continue rising?

The impending and steady rate increases has caused a dramatic rise in bond issuance, as investors pile in to low rate debt securities. Companies sold a record-high amount of bonds in March to the tune of $414 billion, the Wall Street Journal reported earlier this week. This signals that the market believes the Fed’s intentions to raise rates, lending further evidence to the certainty of rate increases.

Perhaps a bigger indicator that rates will continue to raise steadily – and may even have an accelerated pace – is the split between US monetary and fiscal policy. As the Federal Reserve undertakes monetary tightening, the Trump administration and the Republican majority have indicated expansionary fiscal policy in preliminary budgets. This includes infrastructure spending, which Trump has stated could be as much as $1 trillion, as well as increased military and defense spending. Each of these are certain to increase money supply in the economy and drive inflation expectations, which may increase Federal Reserve rate pacing.

Thus, the likelihood of continued rate hikes seems high and potentially increasing. This could signal bad news for both personal income investors who will see the market value of their holdings drop, and institutional investors with actively managed bond funds who will struggle to find profitable investment opportunities. The global impacts will be significant, as the federal funds rate is tightly linked with other interest rates. In fact, one day after the Federal Reserve raised its rates a quarter percent, the People’s Bank of China kept its rates in lock step with its American counterpart.

The markets are headed towards the normalcy previous generations experienced, with 30-year interest rates above 3% and federal fund rate changes that nobody noticed. Now, when a rate hike is expected, it is talked about endlessly weeks before and after. This is good for savers and pension funds, but bond investors are going to suffer during the transition from almost-free money to rates I haven’t seen since I was 12.