The FOMC has issued a warning to bond investors that the pace of rate increases is more likely to accelerate than decelerate over the next two years. The press statement acknowledged that the economic outlook has strengthened and the projections for the fed fund rate have become more bearish. Seven of the 15 Committee members now envision four rate increases in 2018, pushing the rate to the 2 1/4-2 1/2% range by year-end. Eleven members have the rate in the 3-4% range by year end 2019.
It hard to envision how the yield on the 10-year Treasury note could be below 3% if the funds rate is at 2 1/8% or possibly 2 3/8% at year-end. The yield on the 2-year note would probably rise 30-40 basis points and, even with some additional curve flattening, the 10-year yield could increase 20-30 basis points. That would spell steeply negative returns on the longer Treasury notes and bonds. Remember, at year-end, the market will likely be anticipating a funds rate around 3% in 2019.
A more stimulative fiscal policy at a time when the economy is at or very near full employment is clearly a problem for the FOMC. They will not say that directly, but the why else would the majority bump up their rate and GDP forecasts? Perhaps in the weeks ahead Fed officials will discuss this, as they prepare the markets for a more forceful “policy normalization” process. The minutes of this meeting should also contain discussions of the implications of fiscal stimulus for the appropriate path of Fed policy.