What if interest rates rise faster than expected?

The US Federal Reserve may raise interest rates twice as often as the market expects in 2018, according to AMP Capital Head of Investment Strategy and Chief Economist Shane Oliver.

“This year we think the Fed is going to raise rates more than the market is allowing for,” says Oliver. “Market expectations are factoring about two and a half hikes and we actually think they will do four or possibly five hikes this year.”

The Fed raised rates three times in 2017 in response to promising growth signals and falling unemployment. At its last rate hike in December, the Fed raised its forecast for economic growth in 2018 and projected three hikes for the year; however, it omitted previous language about the labour market further strengthening.

This omission, coupled with surprisingly weak inflation readings, have kept a cap on overall market expectations.

Oliver predicts this will change as the year progresses, which in turn will see rates move above their still lower-than-normal levels.

“The US economy seems to have a good head of steam up. There is very low unemployment and declining levels of spare capacity in the US so we think we will start to see inflation in the US head higher,” says Oliver. “That will allow the Fed to speed up the pace of normalising interest rates.”

There will be three major ramifications of this, says Oliver.

“I would be a little bit wary of investing too much in long-term government bonds,” he warns. “Interest rates over the long term will rise, pushing up bond yields.”

He also cautions against industries that usually operate with high levels of debt.

“It means interest rate-sensitive parts of the market will be under a little bit of pressure. I’m thinking here about listed infrastructure, listed real estate and so on. Those parts of the market that have benefited from low interest rates might start to struggle a little bit.”

The other main repercussion will be increased pressure on equity markets.

“There is going to be more volatility this year in response to a more aggressive Fed,” says Oliver. “But I don’t think it’s going to cause a bear market in shares because even though they will go up in the US, other parts of the world will see relatively low rates.”

The Fed elected to leave rates unchanged at its January board meeting. The meeting was the last for Chair Janet Yellen, who took over the job in four years ago when the quantitative easing policies post the financial crisis were in full swing. She was responsible for ending these policies as the US economy picked up, and raising interest rates in 2015 for the first time in seven years.

She is being replaced by US President Donald Trump’s chosen successor, Jerome Powell.