Ameriprise Financial : Rising Rates Become Top of Mind Once Again

Throughout the long path toward monetary policy normalization in the U.S., the Federal Reserve has been more optimistic about the pace of economic recovery than have market participants. The Fed's anticipated trajectory of the rise in the fed funds rate has been consistently more aggressive than that of the futures market. That pattern was reinforced earlier this year when the Fed backed off from its projection of four rate hikes in 2016, conceding that two were more likely. Investors still were skeptical. As recently as one week ago, fed funds futures were indicating just a four percent chance of a rate hike in June, 17 percent in July, and 34 percent in September. It wasn't until December that the odds of a rate hike were even above 50 percent, at 53.

Things have changed quickly, however. Concerned that markets were not fully appreciating its intentions, several Fed officials recently expressed their views that two, and perhaps more, rate hikes this year was still a viable possibility. Futures began to edge higher, but only fractionally. However, after the minutes of the Fed's April meeting were released last Wednesday, those market perceptions of the Fed's thinking changed abruptly. By week's end, the chances of a rate hike expressed in futures had risen to 28 percent in June, 48 percent in July, 60 percent in September, and 75 percent in December.

Markets Remain Somewhat Skeptical on Future Rate Hikes

This new positioning indicates that the Fed has succeeded in getting the market's attention, although not completely. Given the still widespread impression that the economic recovery remains fragile, the market is still judging the likelihood of two rate hikes this year to be a longshot. Although the Fed is not bound by any preset course, it would seem that for two hikes to be a realistic possibility the first one would need to happen soon. The June Fed meeting may be too soon, since the economic data in the U.S., at least beyond the labor market, has only recently started to firm. But the April meeting minutes did make clear that a June rate hike is a realistic possibility.

More likely, it would seem that July or September would give the Fed enough additional data to make a thoughtful decision, not to mention allow for the outcome of the Brexit vote in the UK on June 23. The problem with waiting until September, however, is that it leaves a short window if a second rate hike is forthcoming. The Fed meets in October and again in December. Given how jittery markets have been over the prospect of higher rates, it would seem very unlikely, although not out of the question, that the Fed would move twice within three months.

Whatever the Fed does or doesn't do depends on the economic data. So, we will watch along with the Fed. At the very least, the Fed has succeeded in getting the market's attention so that if and when the next rate hike comes, perhaps sooner than previously anticipated, the reaction will presumably not be as disruptive as it might have been.

Bond Investors Take Note

Bond investors got the message as well. The yield on the ten-year treasury had fallen to 1.70 percent at the end of the week on May 13, not far above its low for the year of 1.66 percent on February 11. By the end of last week, however, the yield had climbed to 1.84 percent. The two-year note, a little closer to the fallout from a potential hike in the overnight rate, climbed to 0.88 percent last week from 0.75 percent the previous week.

Equities rose for the first time in four weeks, although the move was modest. The S&P 500 rose 0.3 percent. The more economically sensitive sectors rallied strongly, while the defensive, interest rate sensitive groups lagged. Financials climbed 1.4 percent, while the KBW Bank index surged 4.2 percent. Energy and tech shares also rose sharply. Conversely, both utilities and consumer staples lost more than 2.0 percent.

How stocks behave from here will be determined in part by how the dollar responds to the heightened awareness of possible rate hikes. Between the end of November and the end of April, the DXY dollar index had weakened by 7.5 percent, taking pressure off energy producers and companies dependent upon foreign revenues. Since the beginning of May, however, the index has rallied by three percent. If the dollar strengthens too much as the Fed considers raising rates while overseas central banks remain exceedingly accommodative, stocks make struggle even in the face of firmer economic data.

Important Disclosures:
The S&P 500 is an index containing the stocks of 500 large-cap corporations, most of which are American. The index is the most notable of the many indices owned and maintained by Standard & Poor's, a division of McGraw-Hill.

The KBW Index is weighted according to capitalization and represents major banks and money centers from across the country.

The U.S. Dollar Index (DXY) measures the dollar's value against a trade-weighted basket of six major currencies.

The views expressed are as of the date given, may change as market or other conditions change, and may differ from views expressed by other Ameriprise Financial associates or affiliates. Actual investments or investment decisions made by Ameriprise Financial and its affiliates, whether for its own account or on behalf of clients, will not necessarily reflect the views expressed. This information is not intended to provide investment advice and does not account for individual investor circumstances.

Investment decisions should always be made based on an investor's specific financial needs, objectives, goals, time horizon, and risk tolerance. Investment products are not federally or FDIC-insured, are not deposits or obligations of, or guaranteed by any financial institution and involve investment risks including possible loss of principal and fluctuation in value.

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