As Fed jacks up rates, bond market warns of potential for economic weakness

  • The Fed raised interest rates as expected by a quarter point so that its fed funds target range is now 1.75 to 2 percent.
  • But more importantly, the Fed raised its forecast to include a fourth rate hike for this year, ending the debate on a divided Wall Street about whether it would raise interest rates three or four times this year.
  • Treasury yields rose but the yield curve flattened to its lowest level since September 2007 after the Fed announcement, signaling fears of future economic weakness.
Federal Reserve Chairman Jerome Powell 
Joshua Roberts | Reuters
Federal Reserve Chairman Jerome Powell 

The Fed sent a hawkish message to markets — more rate hikes are coming and a bit faster than expected, triggering an immediate negative reaction in bonds.

The Federal Reserve raised interest rates Wednesday by a quarter point and indicated that rate increases could be faster and higher than previously forecast, including an anticipated fourth rate hike for 2018.

Treasury yields rose, but the yield curve temporarily flattened to its lowest level since September 2007 after the Fed announcement, signaling fears of future economic weakness or a policy mistake by too aggressive central bank tightening. Simply put, that means short-end yields, like the 2-year, rose faster than the longer duration, or 10-year yield.

Right after the statement, the 2-year and 10-year yields were 0.39 basis point apart, a step closer to inversion. While a flat yield curve is not a problem, an inverted curve, where 2-year yields would be higher than 10-year, has reliably signaled recession. The 2-year Treasury yield initially jumped to 2.60 percent before backing off, and the 10-year briefly edged up to 3 percent.

Fed Chair Jerome Powell spoke specifically to the issue of a flattening curve during his news conference, noting it has more to do with what is appropriate Fed policy and what ultimately is a neutral rate for the central bank. He said it is a topic of discussion among Fed officials. The neutral rate is the interest rate level that is believed to neither stimulate the economy nor create a drag on it.

"We know the yield curve is flattening because we're raising the federal funds rate. It makes all the sense in the world that the short end would come up. ... The hard question is what's happening in long-term rates," he said. Powell said things that move longer end include term premia, expectations for short rates and also buying on risk aversion.

"There may be a signal in that long-term rate about what is the neutral rate, and I think that's why people are paying attention to the yield curve," he said.

The dollar rose, and stocks floundered after the announcement. The S&P 500 had been flat before the 2 p.m. statement, fell slightly and was flat in late-afternoon trading before losing several points. Bank stocks, which benefit from higher interest rates, rose on the news.

"They're doing that because the economy is a little stronger, sooner than they thought, and that's not a bad thing," said Ed Keon, chief investment strategist at QMA. He said he would not change his view on the stock market based on the Fed rate move.

But bonds were sending a different message with the flattening yield curve, according to Joseph LaVorgna, chief economist for the Americas at Natixis.

He said there's a warning in the Fed statement, in the fact it didn't really see much higher inflation and was adding to rate hikes anyway. The curve later came off its low and was at about 41 basis points between the 2-year and 10-year yield.

"The Fed is leaning or more bent to hike, two more times this year and three times next year and there's the possibility of more. ... To me that could be a policy mistake, meaning the Fed goes too far because inflation is not going to be there, and they're going to hike more than what's prudent," he said.

LaVorgna said that's why the 2-year to 10-year curve was flattening, as it warns the Fed about a potential weaker economy in the future.

However, Ward McCarthy, chief financial economist at Jefferies, said part of the flattening is technical, and he doesn't see it as a concern for now. "It's different this time and I'm not worried about it," he said.

"It's kind of standard what happens when the Fed is raising short-term rates, but also I think there are some technical factors, some of which are temporary that are supporting the long end," McCarthy said, noting pension fund purchases are one reason.

The Fed said it expects further gradual increases consistent with "sustained expansion of economic activity, strong labor market conditions and inflation near the committee's symmetric 2 percent objective over the medium term."

Fed officials also cut their expectation for unemployment this year to 3.6 percent from 3.8 percent, and raised their projection for GDP growth to 2.8 percent this year from 2.7 percent.

"The message was pretty good. The Fed thinks the economy is cooking. They think 2 percent or somewhat higher inflation is sustainable. When you look at the GDP forecast, they clearly see fiscal policy as creating of window for them, where it will boost the economy enough to give them the opportunity to withdraw monetary policy," McCarthy said.