Fund managers are betting on more rate hikes than the market and the Fed expect

A growing number of U.S. asset managers say they are expecting the Federal Reserve to raise U.S. overnight interest rates four times this year, more than the three plotted by Fed policymakers and well above the two expected by the market.

That divergence of expectations has some fund managers holding off on buying risky assets as they wait for the possible market volatility that could come with higher inflation expectations.

“It’s hard to take risk over last few weeks and months because we have the view that the rates market isn’t priced correctly,” said Brendan Murphy, head of global and multi-sector fixed income for Standish, a subsidiary of BNY Mellon Asset Management. “Once we’re there we can evaluate what some of the riskier areas we want to take risks in are.”

Fed Chairman Jerome Powell takes the oath of office in Washington, U.S., February 5, 2018. REUTERS/Aaron P. Bernstein

Murphy and a number of other fund managers said they are looking to increase positions in select emerging markets as well as corporate bonds once the market has aligned itself with higher rate expectations.

CME Group’s FedWatch tool shows the market has not yet priced in even three rate hikes for 2018, as evidenced by pricing of Fed fund futures. That continues a consistent trend over the last few years of expectations from the market – often correctly – that actual rate increases will fall below targets of the U.S. central bank.

“The market in general up to this point has had a significantly more negative view of inflation than the Fed did,” Tom Simons, money market economist at Jefferies & Co., said. “That probably leads to a little bit of that disconnect because the Fed had been projecting a turnaround in inflation that the market thought was further off.”

Investors say the Federal Reserve’s expectation for three rate hikes is too low. PHOTO: The Federal Reserve building in Washington

Fed policymakers, led by then-Chair Janet Yellen, said in 2014 they expected to raise U.S. interest rates to between 1.0 – 1.25% by the end of 2015 and to 2.5% by 2016, meaning nine 25 basis point hikes from its level at the time. The Fed managed one hike at the end of 2015 and another at the end of 2016.

The central bank projected and raised rates three times last year, and announced that it would begin to reduce its $4.5 trillion balance of bond holdings, but the market remains incredulous.

“Can there be significantly more than four rate hikes this year? No. Could something go wrong and we only end up with two? Yes,” said Stan Shipley, strategist at Evercore ISI. “So the risk to getting more than four hikes is not symmetric and it’s really hard to see us getting to five.”

So, why are fund managers expecting the Fed to overshoot its targets? Some believe new Chair Jerome Powell favors higher rates than Yellen. Additionally, strong economic data, such as last month’s consumer and producer price index readings, have jumped, signaling a faster pace of inflation may be coming.

Goldman Sachs Asset Management released a note last week saying they expect the yields on the U.S. 10-year note to hit 3.5 percent within the next six months as monetary tightening continues.

Some investors also believe the market is not factoring in the full extent of the recently passed tax reform act, which they believe will prompt companies to beef up capital expenditures and individuals to spend more, boosting U.S. growth and inflation and prompting the Fed to raise rates further.

“If you look at outlooks from CEOs their forecasts are that they’re going to ramp up on cap-ex front,” said Dec Mullarkey managing director Sun Life Investment Management. “This coming year if you get down to 3.5% unemployment it doesn’t feel like there’s much more you can squeeze out of that.”

Dion Rabouin is a markets reporter for Yahoo Finance. Follow him on Twitter: @DionRabouin.

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