Why no change in US interest rates signals ‘higher for longer’

Tim Richardson CFA, Investment Specialist

What’s just happened?

US share markets fell 0.94% last night, while yields on the interest-rate sensitive two-year US Treasury bonds increased 0.09% to close at 5.19%, a 17-year high (bond prices fall when yields rise).

Why?

The US Federal Reserve (Fed) left its key interest rate on hold at 5.25% - 5.50% at its September meeting last night. The decision was in line with widespread market expectations but reflects a growing sense of caution following 11 interest rate rises since March 2022.

However, the Fed released economic projections from individual members - known as the dot plot - which indicated they expected rates to peak after one further 0.25% increase later this year. Moreover, they projected a slower pace of interest rate cuts throughout 2024 and 2025 than had been forecast in June.

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What does this mean for investors?

While no change in rates was expected by analysts, the Fed’s commentary was rather more hawkish than had been expected.

The strength of the US economy was reflected in the Fed’s forecast that unemployment will reach 4.1% by 2024, a lower peak than had been forecast in June.

The Fed comments that “additional policy firming may be appropriate” and that “most participants continued to see significant upside risks to inflation” were received by the market as strong signals it should expect one further 0.25% rate hike.

Bond markets are increasingly coming to the view that the path of interest rates will be far from symmetrical, with the unwinding of tight monetary policy being much more gradual than the path upwards.

The Fed wants to see a weaker economy that will reduce wage pressure and the ability of companies to pass through higher input costs (such as energy) into higher prices.

For global equity investors, this reinforces the importance of investing in companies with:

• Strong balance sheets
• Pricing power
• Earnings growth which has limited sensitivity to slowing consumer spending

Some members also estimated a higher long-term – or neutral – rate of interest, above the Fed’s official level of 2.5%. This suggests a possible structural increase in long-term interest rates.

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