US rates review

Over the past year, heightened financial market volatility and fears over the health of the global economy - primarily led by concerns over a hard landing in China - have weighed heavily on interest rate sentiment in the US. In recent weeks, however, the subsequent ebbing of these concerns, combined with ongoing strength in domestic data, has all but cleared the path for the US Federal Reserve to begin the process of policy normalisation. 

If the Fed delivers a 25bp policy tightening on 16 December, representing the first rise in US interest rates since June 2006, the focus is likely to shift to the pace of the hiking cycle. Given the unprecedented nature of the financial crisis and the length of time that has elapsed since the last rise in US interest rates, quite how the market will react remains highly uncertain. While some have raised parallels with the sharp and sustained bear market that ensued following the Fed's policy tightening in February 1994, there are good reasons to suppose that market reaction this time around will be far more limited. 

Not only is inflation currently less of a threat - annual headline US CPI is running around zero percent - but the Fed is also likely to continue to stress that the path of further policy tightening will be very gradual. The September 'dot plot' signalled the majority of the FOMC's intention of delivering four hikes in 2016. The pace is expected to be a little slower and the FOMC is likely to raise the Fed funds target rate by 50bp next year, to reach 1.0% by the end of 2016. 

For context, in each of the last three hiking cycles, policy rates were raised by 200bp in the first year alone. While the unwinding of base effects is expected to push headline inflation higher in the early stages of 2016, unless concerns over a more precipitous rise in 'core' inflation surface, the impact of higher policy rates is expected to be largely centred around the front end of the interest rate curve. With real rates and inflation expectations expected to drift higher, long-term bond yields are likely to rise only slowly next year. 10-year yields are expected to end-2016 at 2.7%.