Market Insider

Fed signals interest-rate hike coming soon, but doubts remain on how much rates can rise

Key Points
  • Economists maintain expectations for a June rate hike, but the markets have some doubt about how many increases will be done this year.
  • The Fed's comment that some of its members say it would be "prudent" to await evidence before hiking stirred up speculation in the bond market.
Fed set to reduce balance sheet this year

The Fed signaled it could raise rates soon and dismissed concerns about consumer softness and inflation, but some market pros focused on the fact the Fed also looks to be giving itself a way out if the economy does not improve before its June meeting.

After the Fed released minutes of its last meeting, Fed funds futures for June were largely unchanged, reflecting about a 78 percent chance for a June hike. However, odds for a second hike in September fell to 37 percent from 40 percent, according to BMO.

The market has been doubting the Fed's forecast for two rate hikes by year-end, and it continues to have doubts based on the action in futures. Traders have pointed to a weak stream of economic data and concerns about political uncertainty, including delays to pro-growth policies in Washington.

"I think June is still on the table unless the consumer or inflation blows up. They gave themselves an out. That's just prudent," said Aaron Kohli, director, fixed income strategy at BMO. Kohli said traders expected the Fed's minutes to be more hawkish than they were.

Stocks initially moved slightly lower after the 2 p.m. minutes, but then reversed and moved to session highs. Treasury yields moved slightly lower after the minutes but retraced some of the move. The yield, which most reflects Fed action, slipped to 1.29 percent, and the yield was at 1.25 percent from 1.28 percent before the release of Fed minutes.

Fed: Need more proof of Q1 weakness being temporary

John Briggs, head of strategy at NatWest Markets, said some in the markets were focused on language in the minutes about awaiting additional evidence for economic improvement.

"Members generally judged that it would be prudent to await additional evidence indicating that the recent slowing in the pace of economic activity had been transitory before taking another step in removing accommodation," the minutes said.

"I think they're overreacting to that," Briggs said, adding he expects the Fed to hike in June.

The Fed said both softer consumer spending and lower-than-expected inflation appeared to be transitory factors, and officials said they see near-term risks to the outlook as roughly balanced.

Mike Schumacher, director of rates strategy at Wells Fargo, said the Fed appears to be ready to hike in June, but it also left itself wiggle room. "The door is wide open but there is a lot of fudge factor there," he said.

The Fed also provided some details on how it could taper back its balance sheet, an expected move that would include a steady increase in the level of securities it would roll off each month. Economists believe the Fed would pause in its rate hiking, before setting up the program at the end of the year, to slow reinvesting in Treasury and mortgages as securities on its balance sheet mature.

"I think there's still two rate hikes. What they want to do is set up a trajectory so there's a path to rate hikes and unwind the balance sheet in a measured and slow way before Chair Yellen leaves office," said Diane Swonk, CEO of DS Economics. Fed Chair Janet Yellen's term expires in the new year.

Ed Keon, managing director and portfolio manager at QMA, said the release was as expected, but he also said the Fed gave itself an out for June. "I don't think the minutes tell us for sure they're going to move in June, but that's still my best guess. They left the door open for additional data as they usually do," he said. "In my view, June is more than a 50/50 shot, but I think they were careful to include some words that would allow them to pass on June if they thought it was necessary."

Keon pointed to the weak first quarter, with growth of less than 1 percent, and continued negative surprises in second-quarter economic reports, including this week's housing data.

"There's nothing in here to suggest they are not" going to hike rates in June, said Ward McCarthy, chief financial economist at Jefferies. "They're not going to explicitly say we think we're going to raise in June. They were somewhat dismissive of the inflation picture which would be the primary impediment to a June rate hike."

Watch: Fed says balance sheet should be reduced this year

Fed: Balance sheet should be reduced this year