In a note, Fidelity International multi-asset portfolio manager Eugene Philalithis said investors should not expect to see major changes in Federal Reserve policy this year.
“This is the most gradual rate hiking cycle of modern times and the Fed Funds target rate is expected to peak around a neutral level lower than historical averages, reflecting this era’s below long-term trend growth and inflation,” Mr Philalithis said.
Bond markets have already reflected these trends, he added.
“The US yield curve has shifted up and flattened since March and market expectations for US short term rates have meaningfully converged to the FOMC’s forecasts.
“In fact, the market implies there is approximately a 33 per cent probability the FOMC makes three 25bp hikes this year.
“That would take us to a Fed Funds target rate of 2.5 per cent — a level suggested by some as the new neutral rate.”
The current federal funds rate is 1.75 per cent, which was raised from 1.5 per cent following the FOMC’s meeting over the 20th and 21st of March.
Mr Philalithis said the Fed’s “gradual approach” seemed to be “well calibrated”, given accommodating financial conditions and robust growth in the US.
But two risks could change this, he said, the first being “policy error related to the Fed’s balance sheet reduction” and the second being “an unanticipated rise in inflation”, which would push the Committee to raise interest rates faster than expected.
“The extent of the first risk is very difficult to assess given the complexity of how balance sheet reduction affects bank reserves and financial system liquidity. That’s why the FOMC are taking a very gradual approach,” Mr Philalithis said.
“They also have a number of mechanisms at their disposal to refine financial system liquidity if needed.
“But nevertheless, this part of policy normalisation still requires careful watching – it is likely to progress through a period of slowing growth (because now is as probably as good as it gets) and higher Treasury issuance as the fiscal deficit rises.”
