The key development in December 2015 was the long-awaited quarter-point hike from the Federal Reserve. But for all the anxiety about the prospect of the first rise in the federal funds rate in almost a decade, the Federal Open Market Committee’s December actions had little direct impact on rate markets. But in 2016 so far, rate markets have moved substantially, though not necessarily in response to expected future Fed actions.
At the time of this writing, global markets have registered startling levels of volatility in response to a number of familiar themes, particularly China’s economic weakness and oil’s continuing slump. With massive intraday moves in the major global stock indexes, the 10-year Treasury dropping nearly 30 basis points lower than where it began the year, and gold starting to move as if a bear were pursuing it, investors are beginning to question their convictions and wonder if something has slipped in the fundamentals.
From our standpoint, the economic story in the United States remains intact, although manufacturing is contracting and the energy sector is cutting jobs. Overall, the labor market appears to us to be robust, and we are cautiously optimistic that its strength will continue to spread. And while we agree with many that China has given global markets good reasons to worry, we believe that China’s slowdown and the high risk of policy error there will not by themselves have the power to derail improving economic growth and recovery in the developed world. While the risk of sluggish growth is higher, we do not think that — or continued bouts of financial market volatility — materially raises the risk of a U.S. recession in 2016.
Economic growth to justify normalizing policyWhile we now think growth in the fourth quarter of 2015 will come in lower than we expected just a month ago, we also expect the U.S. economy to grow between 2% and 2.5% over the course of 2016, and that the Fed will continue to raise interest rates — hiking rates perhaps two to three times during the year. We believe the moves will occur at a slower pace than in past tightening cycles, however, and that the magnitude of any tightening will depend on the factors that the Fed has been monitoring, such as employment, inflation, dollar strength, oil prices, and financial market volatility.
The U.S. dollar’s performance will be an important determinant of policy. Capital has flowed into the United States because of the relative strength of its economic recovery, causing the dollar to appreciate, which has a similar effect as monetary policy tightening. For example, a strong currency holds down import prices and keeps a lid on inflation — so ongoing strength in the dollar would accomplish some of the tightening for the Fed. On the other hand, if the dollar does not appreciate much, the Fed will have a bigger job to do.
Thus, given our view that the U.S. growth story will hold, and that the Fed will continue to move deliberately, that might allow the yield curve to steepen, particularly toward the second half of 2016.