The current benchmark interest rate is much higher than 2-3 years ago. If you have a home loan, you may have felt the pinch on your mortgage payment. For the savers out there, great news for you, your savings and fixed deposits are earning a lot more nowadays. But will the interest rate stay at this level, go up, or down? Where are interest rates heading?
What Caused the High Interest Rates?
The Fed hiked interest rates at the fastest pace because of the raging inflation we experienced in the past two years.
With inflation hitting 9% at some point in 2022, the Fed had no choice but to hike interest rates to create a restrictive economic condition. This will hopefully contain the inflation and bring it down to the long-term target level of 2%. So, is inflation getting better now? Let’s look at the current US inflation level in comparison to its historical data:
The latest CPI inflation reading for June 2023 stands at 3.0%. The Core CPI (excluding food and energy) is at 4.8%. As you can see from the chart above, we are seeing a downward trend in the inflation number so far. Believe it or not, we last saw 3% CPI in March 2021! Although 3% is still high and way above the target rate of 2%, the current level is already much lower than the 9% we saw in June 2022. Now that we seem on the right track with the inflation number, where are interest rates heading?
The Fed Interest Rates Expectation
If the main reason for the rate hike, inflation, is already moderating, shouldn’t the Fed be more relaxed and not raise the interest rates too much?
From their last FOMC meeting in June, we saw a bit of surprise because the Fed was being hawkish and projected the terminal interest rate of this rate hike cycle to be slightly higher than before. Here are their projected interest rates by year:
They projected the terminal interest rate of this rate hike cycle to reach around 5.6%. This means they still project two additional 25bps rate hikes from the current level. In their previous FOMC meeting, their projected terminal rate was around 5.3%. This further projected rate hike surprised everyone, but this could be the Fed being more cautious with inflation as it tends to be stickier as it enters the lower range. The initial deflation from 9% to 4% may be much easier than 4% to 2%. The US economy and the labor market are still relatively hot, so the Fed has more room to play with the rates to ensure that inflation is contained.
The Fed projected 2024 rates to be around 4.6%. This means they believe they can start pivoting into rate cuts next year. Although 4.6% is still high relative to where rates were this decade, it is still good news because it shows the Fed has confidence that they will have contained the inflation by next year. The rates were projected to be around 3.4% in 2025 and 2.5% in the long run.
From this projection, we can see that the Fed believe they are reaching the tail-end of this rate hike cycle. The ‘Fed pivot’ investors have been waiting for may come as early as next year.
How About the Market Expectation?
The Fed seems optimistic that the worst is already behind us. But how about the market? The market often disagrees with the Fed. Let’s look at the market interest rates expectation:
As we can see from the chart above, the market expects the terminal rate to be around the 5.25-5.50% level. This means one additional 25bps rate hike from the current level. The market expects this rate hike to happen in this July FOMC meeting.
After this rate hike, the market expects the rate to stay there for the remainder of the year before pivoting next year. The rates will gradually decrease next year but are still expected to be above 4% in 2024.
The market seems more optimistic than the Fed, but generally, they are aligned regarding their rates expectation.
Tail-End of Rate Hike Cycle Implication
What do you think? Do you agree with the Fed and the market? If you agree with them, you may want to position yourself accordingly.
For Growth Investors
High interest rates create restrictive economic conditions by making business more difficult to borrow money to expand their business. It also incentives savings instead of spending; therefore, there will be fewer economic activities.
Generally, volatile or highly-leveraged assets do not perform well in a high interest rate environment. Some examples are high-growth stocks, REITs, etc. If you are investors in some of these riskier or highly-leveraged assets, you may have realized that they didn’t perform well last year as the interest rate continued to climb. However, as we pivot into a rate-cut cycle, the silver lining for these assets may start to appear. As the market is forward-looking, we can already observe that some growth stocks have rebounded this year.
But before we get greedy and increase our allocation to these riskier assets, please be aware of the risk associated with a prolonged high interest rate situation.
Recession Risk
If the Fed keeps the interest rates high for too long, there is a risk that the economy will plunge into a recession. Historically, there is a good chance of a recession when the Fed hiked the interest rate so fast and as high as it is now. But again, the recession is not guaranteed. The latest data shows that the US economy is still robust.
Whether or not we will get a recession and how deep it will be depends on the Fed’s action in the next few months and how fast they can react to the potentially weakening economy. The market also agrees with this because the current yield curve is inverted. An inverted yield curve has been a reliable indicator of an incoming recession.
With this recession risk in mind, please exercise prudence when investing. If you want to avoid timing the market, stick to the dollar-cost averaging strategy.
For Fixed Income Investors
For fixed-income investors, it is pretty straightforward. If you believe we are reaching the end of the rate hike cycle, today and the next few months are the time to lock in the higher interest rates.
For example, Singapore Savings Bonds (SSB) offer around 3% p.a. interest rates for ten years. If you lock in this interest rate, even if the interest rate starts to go down next year, you will still enjoy this higher rate for the next ten years. Yay for extra money!
Summary
Overall, inflation seems to be on a downward trend after peaking in mid of 2022. With the receding inflation pressures, the Fed and the market believe they are soon reaching the end of this rate hike cycle. The Fed projects two additional 25bps rate hikes, while the market expects one more 25bps rate hike. The rates will then stay there for the rest of the year before starting a gradual decline next year.
If you agree with the Fed and market expectations, you may want to position yourself accordingly. As always, exercise prudence when investing. Happy Investing!
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Where are interest rates heading?
Let’s look at some of the latest data to guess where the interest rate may go.
— wealthfor.us (@wealthfor_us) July 10, 2023
