Recent financial market volatility and fears of a growth slowdown have led markets to expect the Fed to back off from its previously signalled path for future interest rate increases. At this week’s Fed meeting, we expect Chair Jerome Powell to say that the central bank is becoming more data dependent and less fixed on a gradually rising rate path. The market seems to be interpreting this as the potential for a pause in the hiking cycle.
We continue to believe that the most likely scenario is rates rising this month (though market weakness in recent days has increased the chance the Fed flinches), and then once a quarter throughout 2019.
However, the risks are heavily skewed towards fewer rate hikes, in our view. It would require a significant upside surprise on actual and expected inflation for the Fed to hike at a more rapid pace, while if financial conditions continue to tighten or growth disappoints, US policy makers would likely pause and wait to see how the situation evolves.
When we attach probabilities to the full range of potential outcomes, we arrive at a mean view of two to three hikes for next year. This is the number of hikes most directly comparably to market pricing which also takes into account all possible interest rate paths. It is also similar to the median estimate of rate hikes in the Fed’s own forecast, which is finely balanced at three in September and could easily slip to two in December if two out of the sixteen Fed participants downgrade their forecast.
As shown in the chart below, the market had been steadily converging towards our 'Roadmap' up to early October, having previously been expecting a significantly more dovish rate path than we did. However, the recent return of market volatility – centred on US equities – has led expectations for future hikes to retreat once more.
There is currently less than one rate hike priced into markets for next year, which means that there could be an opportunity again to position for a steeper trajectory of rate hikes in 2019, although this is likely to be highly correlated to equity market moves, at least in the short term.
However many times the Fed hikes next year, there is likely to be more volatility around rate expectations. This is because it’s going to be difficult for the Fed to pull off a soft landing in the US economy. As balancing acts go – this one’s a bit like trying to cross the Mississippi with just a tightrope for comfort!
If rate expectations back off prematurely, the economy might remain robust for longer, forcing the Fed to continue hiking to prevent overheating. Indeed, the near-term outlook for the US consumer, aided by robust wages, lower oil prices and tax refunds in the first quarter of 2019, remains strong. But at some stage (probably in the second half of 2019), the rate hikes and fading fiscal stimulus will likely slow US economic growth.
With wage pressures building, it will be difficult for the central bank to reverse course before unemployment has risen, but once it does start to rise this usually triggers a negative credit cycle, which amplifies the ensuing economic downturn – a real risk for 2020.