As the Federal Reserve prepares to bring interest rates back to normal levels toward the end of next year, cynics fear the shift may generate widespread market disruption. But these critics are for the most part unfair. Unlike previous interest rate hikes, the Fed’s current course of action is well anticipated by the markets, and judging by futures prices and the yield curve for Treasury Bills, the Fed’s upcoming moves are unlikely to roil the broader economy.
Much of the current criticism seems to stem from memories of February 1994, when the Fed squelched growing inflationary pressures by adding 300 basis points to the overnight rate in a single year. Caught by surprise, equities markets fell sharply, losing nearly 3 percent of their value by March 1995. The present situation is unfolding far differently, as the Fed has gone to great lengths to communicate its plans, keeping uncertainty to a minimum.
In addition, markets have been pricing in the coming hike for years. Futures markets and bond yields are aligned to expect a gradual climb in short-term interest rates, topping out at about 4 percent—a low rate by historic standards. The only unknown variable is the exact timing of the rate hike, but since interest rates are projected to rise slowly, markets should hardly be upset if the climb begins a few months sooner than anticipated.
The real mystery right now is the persistent low yield on long-term Treasury Bills. Despite the end of the Fed’s asset purchasing program and the improving economy, investors seem satisfied to purchase bonds with low returns. This is mysterious, as the global economy has been steadily improving—investors should no longer be fleeing catastrophes at home or abroad, or seeking stability at any price. Perhaps some fear that this year’s soft GDP growth is a sign of weakness, and these pessimists are driving down yields. Regardless, this trend should not be attributed to Federal Reserve policies.
All things considered, the business community has little to fear from the pending rate hike. Markets have already accounted for the coming rise, which should produce no greater disruption than the long-anticipated end of asset purchasing—officially over in October 2014. Continued growth in the labor market may push the Fed’s timetable forward, but this will send ripples—not waves—through the market, a minor effect in comparison to the recovery’s rising tide.