Up until the Federal Reserve’s historic December meeting, when the central bank increased its policy rate for the first time since 2006, investors were
fixated upon when the Fed might finally move its policy rate up from the range of 0%–0.25%. The Fed set the rate at the zero bound in 2008 to combat a
plunge in economic growth and to fight disinflationary pressures tied to the debt deleveraging process.
After the Fed’s 25 basis point (bp) December increase, investors are now turning their attention to 2016 and to the entirety of the Fed’s interest rate
cycle. What should investors expect, and how should they position their portfolios?
PIMCO concurs with markets on the ultimate speed and distance of the Fed’s path on rates, which is widely expected to be slow and shallow. Out of the eight
policy meetings the Fed will have in 2016 (see Figure 1), no more than four rate hikes are likely to be announced – half the pace of past rate-hike cycles
– with each rate increase likely to occur at meetings when Fed Chair Janet Yellen is scheduled to hold a press conference. (That said, we expect the Fed
will continue to indicate that every meeting is “live” – i.e., that a rate change is possible at any meeting, press conference or not.)
Our base case is for the Fed to announce three 25 bp rate increases in 2016, lifting its target range to 1.0%–1.25% (up from the current range of
0.25%–0.50%). Our expectation is consistent with where the central bank’s core leaders have indicated they are leaning for 2016, but greater than the two
rate hikes that the bond market is priced for, which itself is instructive on how to position fixed income portfolios at the start of 2016.
Notably, the median projection cast by participants in the Fed’s December meeting reveals policymakers expect four 25 bp moves in 2016, strengthening our
conviction that there will be at least three.
Beyond rate hikes, the Fed in either late 2016 or early 2017 will likely begin to gradually shed the several trillion dollars of bonds it
accumulated in its post-crisis bond-buying binge aimed at stabilizing financial markets. When it does, the performance of agency mortgage-backed securities
and perhaps U.S. Treasuries could be negatively affected.
So, what should investors be looking at to estimate how many rate hikes the Fed will actually deliver in 2016? There are three things in particular:
- Labor market trends relative to the Fed’s projections
- Inflation trends relative to the Fed’s projections
- The amount of rate hikes the Fed’s core leaders expect in 2016 if its economic projections are correct
The Fed’s projections provide guidance on the rate outlook
Of the three factors, probably the easiest to analyze and translate into the likely number of Fed rate hikes is the labor market, mainly because the Fed
provides a quarterly Summary of Economic Projections (SEP) to serve as a guidepost to judge the Fed’s satisfaction with the progress occurring on the jobs
front (see Figure 2).
Utilizing these projections to prognosticate the Fed outlook for 2016 is fairly simple. Basically, if job growth exceeds the Fed’s projections, there could
be more rate hikes than the Fed’s leadership currently expects (four increases instead of three). If weaker, the Fed could move less than the leadership
expects (two or fewer times). The odds of five quarter-point hikes look a lot lower than the odds of two under current circumstances, especially with the
Fed now placing greater emphasis on realized (versus projected) inflation, as evidenced by this important excerpt from the 16 December FOMC statement:
“In light of the current shortfall of inflation from 2 percent, the Committee will carefully monitor actual and expected progress toward its inflation
To be even more specific with respect to how to translate labor market trends into the likely number of Fed rate increases in 2016, consider both of these
- Monthly payroll growth
- The pace of decline in the U.S. jobless rate
On the first factor, it is very important to know that the Fed projects a substantial slowdown in job creation in 2016, owing to a decrease in the
amount of available workers and a maturing of the economic expansion, which is entering its seventh year – quite long by historical standards (see Figure
Specifically, the central bank projects monthly job growth to slow from the 200,000 or so pace of recent years to about 130,000 per month in the second
quarter of 2016 and 100,000 per month by the fourth quarter (see Figure 4). As substantial as the decline is expected to be, and as much as it seems
reasonable to refrain from tightening monetary policy at all, what will matter is how monthly job creation fares relative to the Fed’s projections, because the Fed will view a jobs slowdown as normal for the current stage of the business cycle. This is how to
simplistically determine how the Fed might react to incoming jobs data, assuming all else is equal, which of course it rarely is, so keep a holistic
perspective on the broader economic situation (in the U.S. and globally) as well as on financial conditions.
On the second factor, the jobless rate, the Fed expects a decline of just three-tenths of a percentage point (to 4.7%) in 2016, a remarkably small decline
compared with the past four years when it fell a full percentage point per year. As with the pace of job creation, the speed of progress in reducing
unemployment will have a major bearing on how many times the Fed raises interest rates. If, for example, the jobless rate falls below 4.7%, say to 4.6% or
4.5%, this will raise the odds of four rate hikes. A slower rate of decline would make it more likely there will be three hikes or less, depending upon the
speed of job creation, inflation trends and financial conditions.
Inflation trends: not just about the future
As noted earlier, the Federal Reserve in December emphasized that it will assess the “actual” progress made toward its 2% inflation goal when considering
the timing and size of future rate increases. This is an important transition, with the Fed indicating that the falling jobless rate in itself is not
enough to ensure it will reach its inflation goal. The Fed doesn’t yet know how far the unemployment rate has to fall before inflation picks up.
In essence, the Fed is probing for NAIRU, the non-accelerating inflation rate of unemployment. This is crystal clear not only in the Fed’s inflation
comment but also in the fact that the FOMC lowered the bottom end of its projected NAIRU range three times in 2015, after not having done so at all in the
previous four years. It is therefore critical to elevate the importance of incoming inflation data, even while maintaining a primary focus on the monthly
For 2016, the Fed projects the inflation rate for all goods and services minus food and energy to accelerate three-tenths of a percentage point to a 1.6%
pace (see Figure 2). Use this as a litmus test of how strong the Fed’s inclination will be to raise rates in 2016.
Follow the leaders: three hikes a reasonable baseline for 2016
A reasonable baseline for what to expect from the Fed in 2016 can be developed by considering the rate projections of the Fed’s core leadership, which
consists of Fed Chair Janet Yellen, Vice Chair Stanley Fischer and New York Fed President William Dudley. Here we again rely upon the Fed’s latest SEP and
specifically the “dots,” which are projections for the policy rate from individual policymakers. Close inspection of each participant’s publicly expressed
viewpoints suggests that the Fed’s core leadership expects three rate increases in 2016, making three a reasonable baseline.
Conclusion and investment implications
Predicting what the Fed will do in 2016 is likely to be easier than it has been in quite some time. Start with three hikes as a baseline, and then adjust
the expectation up or down primarily based on labor market trends, putting the jobs data in the context of incoming inflation data. Then consider financial
conditions, because the movement of stocks, bond yields and the value of the U.S. dollar can all influence the U.S. economic outlook and therefore the
Fed’s decisions on interest rates.
The bar for moving five times in 2016 is probably a lot higher than for moving less than the four that the median of policymakers project in the SEP,
because the Fed has made it abundantly clear that it wishes to be cautious about normalizing its policies, saying twice in its December policy statement
that it expects only “gradual” increases going forward.
For fixed income portfolios, our expectation that the Fed will move more than markets are priced for has a number of broad investment implications. That
said, we believe that markets will be well-anchored over the medium term by expectations for global policy rates to stay below historical norms throughout
the rest of the decade.
- In the near term, with markets underpriced for the Fed’s likely policy path, we suggest that investors consider keeping the duration of their fixed
income portfolios shorter than normal to hedge against a rising rate climate. Focus in particular on underweighting duration on the shorter end of the
yield curve, which will bear the brunt of Fed rate hikes.
- Second, in the context of our longer-term view on rates, we suggest keeping dry powder to take advantage of any market volatility that emerges in the
rate normalization process, with an eye on adding to positions in credit instruments: non-agency mortgage-backed securities, corporate credit (both
investment grade and high yield), bank capital and European peripherals.
- Finally, expect continued strength in the U.S. dollar owing to the divergence between monetary policies in the U.S. and abroad.
Fed watching is always more art than science, but in 2016 science is apt to help Fed watchers to delineate what to expect next from the world’s most
closely watched central bank.