While much of the investment world has focused on this year’s rising equity prices and low volatility, the U.S. Federal Reserve (Fed) has been methodically raising rates in line with its projections. Today, those projections could be a warning sign for U.S. equities.
Federal Open Market Committee (FOMC) forecasts for this year—commonly known as the Fed's dot plot—were nearly spot-on. The median forecast of FOMC members in late 2016 called for a fed funds rate of 1.4% at the end of 2017, and after three 0.25% increases, the fed funds rate today stands at 1.5%.1 Whereas the Fed managed to raise rates this year without triggering market volatility, a repeat performance in 2018 could prove more difficult and create volatility if the Fed follows through on its projections and the Treasury yield curve inverts.
The Fed’s current forecast for 2018 calls for two to three additional 0.25% rate hikes and a target fed funds rate of 2.1% at the end of the year. That would put the yield curve on the brink of inversion if the 10-year yield stays near today’s levels. As a refresher, an inverted yield curve occurs when shorter-maturity Treasuries yield more than longer-term bonds, a scenario commonly measured using the 2-year Treasury yield relative to the 10-year Treasury yield. The consensus among investment strategists and asset managers in our network is that an inverted Treasury yield curve is one of the most reliable indicators of a coming recession. The basic rationale is that the Fed is raising short-term rates to cool off the economy to a level that is generally not warranted by the growth prospects being priced into longer-term Treasury yields. If the Fed follows through on its projections, an inverted yield curve is a very real possibility in the year ahead.
However, the dot plots are not set in stone, and the FOMC has been known to deviate from projections in the past. The 10-year Treasury yield may also rise in 2018. Based on conversations with our research network, we see two possible scenarios for avoiding an inverted yield curve in the year ahead.
Scenario 1: The Fed doesn’t follow through on its projections and raises rates more slowly. This view is shared by several fixed-income managers in our network who expect that the Fed will look for more durable signs of inflation before choking off the economic momentum of recent years. In this scenario, we would likely see a relatively flat, but not inverted, yield curve.
Scenario 2: The 10-year Treasury yield rises during 2018, causing a slight steepening of the curve. There are two key drivers that could make this happen, according to macro strategists in our network. Inflation expectations in the United States could rise alongside actual inflation, or foreign central banks could tighten monetary policy more than expected, causing yields to rise globally—including in the United States. These appear to be less likely, but certainly could happen. Global inflation may tick upward off extremely low levels, but it’s hard to paint a picture of meaningful inflationary pressure. In fact, the European Central Bank and the Bank of Japan have both foreshadowed an extremely accommodative policy into 2018.
The base case we outline in Market Intelligence is that the Fed proceeds at a cautious, data-dependent pace in 2018, resulting in a flatter, but not inverted, yield curve. Should the curve invert, investors may wish to consider adding exposure to asset classes that offer protection from equity volatility, including lower-beta alternatives and high-quality government bonds.
1 FactSet, New York Fed, 12/15/17.