A look at Fed policy and equity markets

Vanguard’s Global Chief Economist Joe Davis explores interest rate policy and the impact of raising short-term rates in 2018 as the Fed continues on its path to normalization.

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Rebecca Katz: Frank wants to know, “What effect will Fed policy have on equity markets?” So maybe we can just explore interest rate policy and what we’re thinking there.

Joe Davis: Yes, and it’s one of the biggest risks we talk about. So we see short-term interest rates going up. More importantly for investors, the bond market is anticipating that as well. That’s why the yields on longer-term bond funds generally have a higher yield than the short-term bond funds, although that difference has narrowed. And our baseline assumption and central tendency is that long-term interest rates, so those that say the ten-year Treasury security, those on a 30-year mortgage that are tied to, those on a long-term bond fund, municipal or taxable, corporate or credit, we’re hard pressed to see a material rise in long-term interest rates with wiggles around that.

That’s, in part, because of what’s happening at short-term interest rates that are controlled by the Federal Reserve, in part, because I think the Federal Reserve will continue on its normalization path. And, if anything, maybe a little bit more aggressive than the bond market’s expecting for 2018. Inflation may tick up a little bit more, and unemployment rate will continue to tick down. So what that means is the Federal Reserve will be extremely likely to raise rates in a week or two, in a week. That will bring the short-term money market equivalent, the fed funds rate at close to 1.5%, and they anticipate raising rates three times next year. The bond markets think it’s best to. For the first time in ten years, I think the Fed actually will be right.

But that puts short-term interest rates—so those that are in money market funds, like my father, in part, savers who have subsidized this financial recovery through negative real interest rates—the good news is that we should see continue with the recovery higher short-term interest rates. But, in part, because that happens, inflation is unlikely to material rise. And so if short-term interest rates rise, the expectation, at least I personally have and our outlook has, is that there’s not a material change in long-term interest rates. So the yield curve will flatten. And I think that’s important to recognize because to say that interest rates are going up, that’s not necessarily have a one-for-one mapping, depending upon what interest rate sensitivity you have to your portfolio. If we’re talking about a mature rise in long-term interest rates, which we’ve been on this webcast for several years, there’s been a number of concerns around that, we have not had those concerns. It’s still possible. But I think to do that, it has to be more than just the Federal Reserve raising rates in 2018.

Rebecca Katz: It’s much more tied to inflation.

Joe Davis: It has to be inflation. It also has to be the ECB [European Central Bank]. It has to be Europe central banks raising rates appropriately. That means inflation’s got to be global. We have to have Japan, Bank of Japan, loosening their 0% interest rate target for long-term interest rates. So it’s got to be a much more global, genuine phenomenon rather than simply the U.S. raising rates short term.

Rebecca Katz: And do the short-term moves by the Fed have an impact on the foreign banks and what they have to do?

Joe Davis: They do, but if anything, we’re pulling away from them. So if anything, it will be a slight divergence for 2018. In many ways, the United States is three years ahead of the business cycle for, well, Japan, longer than that, but for Europe. So Europe is starting to see this sort of stronger recovery relative to where they were, much like we saw in 2011, 2012.

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