Why a Fed rate hike could actually boost the bond market
With a rate hike all but certain next week, the question remains how many will follow this year, and the bond market may see primary activity increase as issuers move to get deals done before rates go any higher.
The Federal Open Market Committee is expected to raise the federal funds rate target 25 basis points to a range of 1.75% to 2% at its meeting June 12-13, with at least one increase, and possibly two, to follow this year, according to Fed watchers.
“I am with the majority who expect the Fed to hike their target fed funds rate again at the meeting next week,” said William Norris, chief investment officer at CIBC Bank USA in Chicago. “Given the high probability for the hike, the impact has already been factored into the markets. Municipal bond yields generally have moved higher this year in response to the Fed moves and I would expect that to continue. But the magnitude of the yield moves has been offset by stronger demand from investors for municipal debt.”
Looking beyond, traders will parse the post-meeting statement and fed Chair Jerome Powell’s press conference for clues about Fed thinking on future rate hikes. “Anticipation of higher rates could actually lead to a boost in issuance over the next few months in the muni market as issuers look to lock in today’s financing rates,” Norris said.
Alan Rechtschaffen, portfolio manager and senior vice president at UBS Financial Services Inc., also expects a rate increase, and another one or two this year, depending on data, as the Fed tries to “get back to a place of normalcy.”
As monetary policy nears normal, the Fed can “reassess” and be “flexible,” Rechtschaffen said in a Bond Buyer podcast where he discussed the coming meeting, the possibility of a rate curve inversion, and the normalization process.
For now, “the future looks good,” he said.
The latest FOMC meeting minutes “gave me the sense that the discussion at the meeting appeared to be more straight-forward than in the past,” said Bryce Doty, senior vice president with Sit Investment Associates. “Maybe it’s a reflection of Powell’s more direct and matter-of-fact style relative to [former Chair Janet] Yellen, or perhaps it’s all in my head. The mood regarding the economy was the most upbeat since before the financial crisis. I got the sense that if there had been a press conference scheduled, that they would have raised rates.”
Despite that, there were no hints that the Fed would move faster than the gradual pace they’ve been touting. “Bond investors were relieved to see continued restraint though as the Fed made it clear that they will not be accelerating the gradual pace of rate increases,” Doty added.
“Fed rate expectations and inflation expectations should support rising yields,” according to Bill Merz, a Minneapolis-based director of fixed income at U.S. Bank Wealth Management. “Market odds of the number of Fed rate hikes have fluctuated and now price in a 14% chance of a fourth hike this year. We continue to expect a total of three increases of 0.25% each in 2018, but the odds of a fourth are still meaningful.”
The post-meeting release also features an updated Summary of Economic Projections. Morgan Stanley researchers expect the summary to look similar to the prior one, suggesting three hikes for 2018. “We expect the ‘dot plot’ to continue to suggest a likely path of 3 hikes this year and next — in line with our forecast for the target range,” Morgan Stanley economists, led by Ellen Zentner, wrote in a note. Morgan Stanley also raised the possibility that the post-meeting statement will add the word “modestly” before accommodative when describing monetary policy.
The Fed is likely to make a technical adjustment to its balance sheet, raising the interest rate on excess reserves (IOER) by only 20 basis points, according to the Morgan Stanley note. “We expect this technical change will be detailed in the accompanying implementation note, not in the statement itself.”
And with the smaller IOER increase, “the June hike will feel a lot more like 20 than 25bp,” according to Bricklin Dwyer senior U.S. economist at BNP Paribas. Dwyer expects a higher 2018 GDP forecast, cuts to the expected unemployment rate, but no change in the dot plot, although that could change in the September release.
Pointing to the minutes from the May FOMC meeting, he said, “we could see some forward guidance language removed from the statement in addition to cutting ‘roughly’ from the balance of risks.”
BNP projects four total rate hikes this year. “For 2019, we think the Fed will be nimble and quick to pause its rate hikes in the face of slower growth and greater uncertainty — faster growth or inflation would result in more hikes.”