When will the Fed rate hikes become a problem for the economy?

February 18 edition of the UBS Global Risk Radar

12 Feb 2018

After nearly 10 years of uninterrupted economic growth, the US continues to lead the global economic recovery. As the business cycle matures, a growing shortage of workers should start to contribute to inflationary pressures. In the meantime, business and consumer sentiment is running close to all-time highs, while real GDP grew at a 2.6% clip in the fourth quarter of 2017.

The Federal Reserve has already started raising interest rates and begun to reduce its balance sheet. With five rate hikes under its belt since December 2015, the upper bound of the federal funds rate target range now stands at 1.5%.

Our view

Base case

CIO expects three Fed rate hikes in 2018, bringing the fed funds rate to 2–2.25% by the end of this year. Economic growth should remain strong as inflationary pressures continue to build up gradually. Core personal consumption expenditures (PCE), the Fed's preferred measure of inflation, grew 1.5% in December, still comfortably below the Fed's 2% target. This relieves some of the pressure off the Fed for now.

Risk case: Fed ends the cycle

CIO believes that the risk of a Fed-induced market downturn in the coming months is very low. If the Fed saw first signs of rapidly rising inflation or a substantial buildup of wage pressures, it would likely decide to start to raise interest rates more frequently. But even if this were to happen, the fed funds rate would need to rise quite substantially from current levels before it could become a problem for the economy and markets.

Investment conclusions

We may see further flattening in the US Treasury yield curve and a gradual rise in market volatility up ahead; however, in the absence of a material risk event, the outlook for risky assets remains favorable over our tactical horizon of six to 12 months.

Related investment ideas

  • Short-term idea (view of less than six months): CIO is underweight 2-year US Treasury notes against both longer-term US Treasury notes (on a duration-neutral basis) and the S&P 500 (see CIO Short Term Investments series).
  • Equities: CIO believes it is too early to reduce exposure to equity markets, as equities tend to experience some of their best rallies when the economic cycle matures.
  • Equity sectors: Financials and IT are some of the best-positioned sectors, while defensive sectors like consumer staples and utilities may underperform until a later stage when markets start to turn. CIO is currently overweight technology and underweight consumer staples in its sector strategy for both Europe and the US.
  • Credit markets: Corporate bonds may fare a bit worse than equities overall, as credit spreads tend to start widening late in the cycle – before equities start to show any signs of weakness.

Download the full February edition of the Global risk radar.

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