The Federal Reserve Board met last week, and as expected, it did not move interest rates higher. However, the committee did voice their intention to raise the rate three times in 2018, and the announcement of higher interest rates seems to be troubling markets. This past week, we saw an unprecedented rise in bond yields; the 10-year bond increased more than 250 bps. That is nearly 10% higher than it was the previous week!
Sharp moves like that are not uncommon. In fact, we saw a massive rise in bond yields in late 2016. The 10-year bond rose from 1.8% to about 2.6%, right after the Fed raised rates for a second time.
Don’t fear higher interest rates
The Fed is currently normalizing the curve by adjusting the Fed Funds while trying to unload bonds from its bloated balance sheet.
But bond investors remain spooked. Yields typically rise due to higher inflation. Bond investors abhor inflation and will sell bonds at a moment’s notice. Though they know that the Fed are “inflation fighters first”, they do not believe that the committee can reach its target of 2% inflation. However, we may be seeing lower inflation, and that isn’t a bad thing.
Economic growth is strong; some estimates have this first quarter of 2018 coming in at a blistering 4%+ pace. That would be ideal, but only if productivity improves and inflation is tame. The yield curve has been steepening, with all segments of the curve rising in concert.
So we have a market making an adjustment to a more normal environment. What do I mean by “normal”? The generous and unprecedented accommodation policy put in place by the Fed more than nine years ago is coming to an end. The Fed waited until the economy could handle a reduced balance sheet (theirs) and higher interest rates. With a strong fiscal policy in place (tax cuts, potential infrastructure spending and less dependence on Fed policy), perhaps the moment has arrived that everyone has been waiting for – the Fed will step aside.
A normal economic cycle with booms and bust periods is healthy for the economy over the long term. The fine-tuning that Fed policy typically does may just do the trick. When the media cries about higher interest rates dooming the economy or growth plans, don’t run away – just embrace it.
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