Fixed income ETF investors are bracing for another wild week as the Fed gears up to hike interest rates for the first time since 2018.
After months of fretting about what the Fed might do at this week’s meeting, market expectations have coalesced around the U.S. central bank increasing its federal funds rate by a quarter of a percentage point. That would mark the first rate hike since December 2018, when the Fed increased rates to 2.5%, completing a three-year rate hiking cycle that began with rates at zero in 2015.
This time around, rates are again at zero—or at least the federal funds rate is. From 2.5% in 2018, the Fed lowered its benchmark rate all the way back down to rock bottom levels in response to the COVID-19 pandemic. But the monetary support is no longer warranted with the economy growing briskly and unemployment close to prepandemic lows.
A new rate hiking cycle is about to begin.
Fed Funds Rate
Sense Of Urgency
While each cycle is different, this upcoming Fed hiking campaign comes with a sense of urgency that arguably wasn’t evident last time around. Unlike 2015—when deflation was more of a concern than inflation, and the Fed was merely attempting to “normalize” monetary policy—today, there are real fears about rising prices.
Inflation is at a 40-year high, and expectations are that it could move even higher on the back of the commodity supply shocks from the Russia-Ukraine war. Some economists have suggested that the Consumer Price Index could grow by 10% or more in the coming months.
That’s a scary thought, and no doubt one that keeps Fed officials up at night. Even before the war, the central bank was in for a tough slog and an extended rate-hiking campaign. Now inflation is even more of a worry, but suddenly the Fed has to consider the negative economic impact from the commodity supply shock as well.
What was a booming economy with high inflation may turn into a weaker economy with even higher inflation. The Fed’s job has gotten much harder.
Yet even though growth and inflation are in a more precarious position than they were before, the Fed is unlikely to deviate from its measured approach to tightening monetary policy. The central bank is well aware of how fluid the economic situation is, and making drastic moves as some have suggested it should isn’t in the DNA of the current Fed. That’s why a 50 basis point hike this week is unlikely.
Besides, market-based interest rates and financial conditions in general have tightened significantly in anticipation of the Fed’s moves. The two-year Treasury yield is around 1.8%, up from 0.1% a year ago; the 10-year yield is at 2.1%, up from 1.6% a year ago; junk bond yield spreads topped 4% for the first time since late 2020; and the Goldman Sachs U.S. Financial Conditions Index, similarly, hit its worst level since late 2020.
In other words, the market has moved well in advance of the Fed. Indeed, you can argue that at least six Fed rate hikes of 25 basis points are already priced in. The more important question is whether those rate hikes will be enough to tame inflation and whether the economy will remain robust enough to absorb those rate hikes while also grappling with a more challenging consumer spending backdrop.
The Fed certainly hopes that its rate hikes will be aided by improving supply chain conditions and an end to the Russia-Ukraine war/commodity price spikes. But those can’t be counted on—and there’s the possibility that things could go the other way and get worse.
That’s why the Fed will probably stress how dependent its moves will be on incoming data and events abroad.
The Fed makes its decision at 2:00 pm Eastern Time on Wednesday, March 16.
Returns For Select Fixed Income ETFs
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