The U.S. economy has been in growth mode since 2009, and many investors have been anticipating significant interest-rate increases. This may be a logical expectation because, historically, the Fed has raised rates to slow down the risk of inflation during market expansions. Our current economic growth, as measured by GDP, is greater than 2.5%, and unemployment is approaching generational lows of 4%. And, if Congress passes smart tax reform legislation, then our economy could heat up even more, which could put more upward pressure on interest rates.
However, despite these and other strong economic indicators, the Fed kept its target Federal Funds (“Fed Funds”) Rate near zero from 2008 until 2015. Since then, the Fed has made only a handful of quarter-point increases to this highly watched barometer. The Fed Funds Rate is now at 1.25% with one probable year-end hike in the cards. The current rate range is much lower than its historical average and certainly lower than it’s been in other periods of economic expansion. Looking into 2018, many economists are expecting two or possibly three increases, but other factors may impact how rapidly the Fed will move to raise rates.
The Fed sets short-term interest-rate policy through a variety of maneuvers (e.g., setting the Fed Funds Rate) and through open-market operations (e.g., buying and selling bonds). When the Fed buys bonds, as it did following the 2008 market crash, it is adding liquidity to the financial system, which pressures interest rates lower. When it sells bonds, it is removing liquidity from the financial system, which can move rates higher. Both of these actions have more influence over short-term bonds than longer-term bonds, which is why it is often said that the Fed primarily influences the shorter end of the yield curve (e.g., bonds with about 3 years or less to maturity).
In the past two years, the Fed has raised the Fed Funds Rate and stopped its open-market bond purchases. Recently, the Fed announced it will also shrink its balance sheet and sell bonds into the open market. As a result of these moves, shorter-term interest rates have risen thus far in 2017, while interest rates on longer-duration bonds, such as the ten-year Treasury note, have actually declined.
|Bond||January 3, 2017 Yield||November 24, 2017 Yield||Basis Point Change|
|2 Year Treasury Note||1.22%||1.74%||.52|
|10 Year Treasury Note||2.45%||2.34%||-.11|
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