After spending nearly a decade near the 0% mark, short-term interest rates finally got a boost when the Federal Reserve moved to raise its federal funds rate by a quarter percentage point in mid-December. The move wasn't a huge one in terms of its magnitude, but as a symbolic gesture, it opened the door to a change in sentiment that could have major implications for the bond market for years to come. In particular, bond investors are now uncertain about the timing of future rate increases and just how quickly the Fed plans to get back to a more typical rate environment. Let's take a look at some insights into what could happen with interest rates in 2016.
Rates and the futures market
Investors put their money where their mouths are when they invest in futures tied to short-term interest rates. By looking at futures contracts on the federal funds rate, you can get a sense of where market participants expect rates to go.
Based on current prices, investors expect a very gradual tightening of monetary policy over the next couple of years. March futures suggest about a two-thirds chance that the Fed will have boosted the funds rate by another quarter percentage point, and by next December, the expectation is for rates to be somewhere between 0.75% and 1%. Yet the measured pace of higher rates is expected to continue into 2017 as well, with year-end 2017 interest rates projected to be between 1.25% and 1.5%.
What the Fed thinks
Interestingly, the futures market appears to be more conservative in how far rates will rise than the Fed itself. The FOMC's own projections show that it expects the funds rate to be between 0.9% and 2.1% in 2016, rising to 1.9% to 3.4% in 2017. The median projection is for fed funds to finish at 1.4% for 2016 and 2.4% for 2017, and while those medians haven't changed much in recent months, the size of the ranges has narrowed considerably from what policymakers believed in September.
The Fed's expectation that GDP growth and inflation will remain near current levels should support fairly smooth moves in interest rates in 2016. The central bank expects real GDP growth to accelerate slightly in 2016, and inflation readings should return much closer to their 2% target once the downward impact of falling energy prices works its way completely through the economy.
What bond investors think
Perhaps the best sign of confidence that interest rates aren't likely to rise at a quick pace is that interest rates on longer-term bonds haven't spiked higher in light of the recent Fed move on the shorter end of the yield curve. Typically, when bond investors expect a rapid succession of tightening moves, they push long-term rates higher in anticipation. Some policymakers note that the Fed would prefer not to have a major spike in long-term rates, as the impact on investment could pull away some potential growth-producing moves in favor of sinking money into risk-free Treasuries.
Nevertheless, it's important to note that bond investors have had a lousy track record in predicting the direction of interest rates in recent years. Consensus expectations have been for rates to rise much more quickly than the Fed eventually did, as investors apparently underestimated how patient the central bank would be in making sure it didn't commit the error of tightening too soon. The usual penalty for waiting too long is inflation, but with commodity prices still very weak, inflationary pressures don't appear imminent.
Predicting the future course of interest rates is hard even for a single year. With the Fed having communicated the likelihood of further upward moves throughout the year, it'll be interesting to see just how aggressive the Open Market Committee is in following through on its stated preference for returning monetary policy to a more normal approach this year and beyond.