New Fed Chairman Jerome Powell signaled at least the possibility of a more hawkish stance on interest rates at his first Congressional testimony. Mr. Powell said the economy had been stronger this year than he expected in December and that the FOMC would strike a balance between avoiding an overheated economy and bringing PCE price inflation to 2%.
1. There is no predisposition towards raising rates or higher inflation expectations. The FOMC’s decisions are data dependent and the decision is by popular vote of its 12 members.
2. That said, unless data is unusually weak, the Fed will seek to normalize its policy tools for future use. That means that rates are likely to rise in line with what the Fed has signaled unless data surprises on the weak side.
3. The Fed may be raise rates more aggressively than signaled. The Fed has signaled 3 rate hikes for 2018 based on market conditions last year. This year, the risk of trade protectionism has risen, so too have energy and commodities prices while the USD has been weak, all inflationary factors. Above and beyond this is the risk that higher rates themselves reduce excess capacity and raise costs of capital. The stickiness of real interest rates could translate into rising inflation as nominal rates are raised.
Short rates have already reacted to the signals by the Fed and may overshoot draining liquidity from money markets.
Longer dated yields have so far been less sensitive leading to curve flattening as inflation has been more of a concern than a reality. This could change.
Another factor will be resurgent US treasury issuance with heavy issuance at the short and intermediate maturities. The need to finance the tax reform and deficit budgeting will increase supply of treasuries just as the Fed is reducing bond purchases, China looks more reticent to finance the US and inflation expectations are rising.
For our portfolios, we have maintained caution on duration and kept duration low at the very least, hedged in the base profiles and negative in more aggressive portfolios.