Vanguard Chief Investment Officer Gregory Davis thinks the Federal Reserve will ultimately raise interest rates further than financial markets now expect.
“The Fed will have to be more aggressive than what’s priced in the market, long-term,” he told Barron’s. “Our long-term expectation for the neutral rate is closer to 2.5% to 3%; the market is expecting 2% to 2.5%.” He’s talking about the federal funds rate target, which is now zero to 0.25%.
“They [the Fed] are going to have to go a bit further to keep a handle on inflation longer term, but we think they will be successful in making sure it doesn’t get out of control,” Davis said.
The Fed, of course, is poised to raise rates to combat raging inflation, which totaled 7.5% in the 12 months through January, an almost 40-year high. The Fed has indicated it will start raising rates next month, and many expect the initial hike to be 25 basis points.
Economists have predicted up to seven rate increases this year, totaling as much as 175 basis points. Interest-rate futures traders have priced in a 70% probability that the Fed will lift rates by at least 150 basis points this year.
With the Fed tightening, Davis sees a better outlook for bonds than for stocks, he told Barron's. “If you start to see the Fed get aggressive in raising rates over the course of the next couple years, and the 10-year [Treasury] is hovering around 2%, we could get to an environment where segments of the bond market look more attractive, given the risks in the equity market,” he said.
“The backdrop of still-low-but-rising yields, reduced policy support from the Fed, and already-stretched equity valuations suggests a challenging environment for the equity risk premium in the years ahead.
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