In Spite of the Fed’s Recent Action, Interest Rates Will Remain Low – HomeUnion

In Spite of the Fed’s Recent Action, Interest Rates Will Remain Low

By Steve Hovland
Director of Research, HomeUnion®

The Fed’s long-awaited announcement that they would begin to draw down their record balance sheets left markets wondering how significant the impact would be on long-term interest rates. At least initially, the impact will be relative muted for a number of reasons, including market expectations, low inflation and geopolitical pressure. Along with measured GDP growth, the trajectory of interest-rate gains will be low through the current growth expansionary cycle.

After ambiguity shrouded actions of the Fed during the initial tightening of monetary policy, the Federal Open Market Committee (FOMC) transitioned to a much more transparent stance. As a result, the move by the Fed to unwind its $4.5 trillion balance sheet has been largely anticipated and already priced into interest rates . Only an aggressive wind down would likely have a significant impact on long-term rates. Thus far in 2017, two interest rate hikes and the expected reversal of quantitative easing has had zero impact on long-term rates. A steady, predictable path by the FOMC will likely mitigate upward pressure on long-term interest rates.

Low inflation expectations will also deter a rapid change in long-term rates. Little upward pressure is being applied to the basket of goods the Fed uses to measure inflation. Absent stronger inflationary pressure, the FOMC will be reluctant to pursue an aggressive rate hike trajectory. Wage growth will increasingly become a factor in FOMC decision making, further supporting a conservative tightening in economic policy.

Mortgage Rates Expected to Remain Low
Mortgage rates are dictated by the rate on 10-year Treasuries. Despite Fed action, plenty of capital continues to flow into the bond market due to geopolitical reasons. Negative to zero interest rates in Europe and Japan increases the attractiveness of U.S. Treasuries. China’s bond market is starting to open, but is unlikely to be seen as an alternative to the safety of U.S. bonds. Brexit, tensions on the Korean peninsula, and a slowdown in emerging market economies will keep Treasuries attractive. U.S. Treasury rates are expected to remain low, mitigating Fed action on mortgage rates.

The final factor impacting a low trajectory for interest rates increases is the pace of economic expansion. U.S. GDP growth appears poised to remain in the low-2 percent area for the duration of the current economic expansion. No single industry has emerged to provide a “break out” for the economy, which is now eight years into a recovery. The longest post-war expansionary period measures 10 years. We expect to eclipse that figure, but we are in a mature period of expansion. As a result, the secondary jobs (leisure and hospitality) that are being created are typically lower paying and provide very little support to overall wage growth. Absent stronger wage growth, the FOMC will not aggressively tighten monetary policy.

To be sure, interest rates will rise as the Fed begins to apply pressure, but we don’t think the trajectory will be significant enough to derail the current level of economic expansion. Nonetheless, increasing rates make leveraged investments more attractive today than they will be until the next recession.

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