In a move Ebenezer Scrooge would approve of, the US Federal Reserve is widely tipped to raise interest rates just a fortnight before Christmas. However, the Fed's cautious moves have not crashed the global bond party, while Australia's central bank is far from taking the punch bowl away.

Market expectations are nearly unanimous for another 0.25-percentage-point rate hike at the 12-13 December Federal Open Markets Committee (FOMC) meeting. This would mark its third increase this year and take the official federal funds rate to 1.5 per cent.

Traders also see a 60 per cent chance of another increase in June 2018, according to a Reuters analysis of Fed funds futures.

Meanwhile, US President Donald Trump's nomination of Fed governor Jerome Powell to succeed Janet Yellen as chair is also seen ensuring a continuation of Yellen's gradual tightening.

Morningstar's John Likos, director, equity & credit research, suggests investors can expect a Fed hike next month and another two in 2018.

"At this stage it will take quite a shock event to stop the Fed from hiking--a December increase is already priced in by markets, so I don't expect to see much activity once it's announced," he said.

Likos said the Fed had been careful to reassure financial markets by telegraphing its monetary policy decisions in advance. However, a faster pace of tightening could hit fixed-income investors.

"If there are three hikes in 2018, I don't think it will surprise too much. But if you get four or more, then fixed income might suffer materially, and then you might see spill over into other asset classes. It's largely contingent on the American economy," he said.

The US jobless rate has dropped to 4.1 per cent, with the economy expanding at an annualised pace of 3 per cent in the third quarter.

Yet with inflation staying below the Fed's target of 2 per cent, the Fed's latest statement indicated only gradual tightening, saying that the federal funds rate would "remain, for some time, below levels that are expected to prevail in the longer run".

With US bond yields only slowly rising, the 20-year bond bull run appears far from finished.

Australia: lower for longer?

In contrast, interest rates in Australia are seen remaining lower for longer, amid lower-than-expected inflation, weak retail sales, and sluggish wages growth.

Morningstar's head of equities research, Peter Warnes, suggests the Fed "could raise the federal funds rate four times, or by 1 per cent, before the RBA [Reserve Bank of Australia] moves".

In its latest meeting, the RBA left official interest rates at a record-low 1.5 per cent for the 15th straight month, with inflation and wages growth remaining weak. In its November "Statement on Monetary Policy" the central bank indicated that inflation would not reach 2 per cent until the end of 2019, dampening expectations of any near-term rate hike.

"Market interest rate expectations have already fallen a long way towards our view that the RBA won't hike rates until late in 2019," Capital Economics said in a 10 November report.

Morningstar's Likos even suggested the possibility of a downwards move on rates, should the economy weaken further.

"Inflation numbers are weak, as are retail spending and household saving, which is further compounded by high levels of household debt. You saw recently the futures market really pare back its expectations of the next cash rate increase, by six months to the second half of 2018," he said.

"If we continue to see weak retail numbers, lower levels of household savings, and a retreat in housing prices, I wouldn't rule out a cut."

For fixed-income investors, Likos said this uncertainty pointed to a generally favourable environment for fixed-income investing.

In the hybrid sector, Likos said the market had benefitted from a lack of supply, but pricing could weaken in 2018 amid an expected pick up in issues by the big four banks.

"There are a lot of issues in the six to eight-year timeframe bucket now. We prefer investors stay shorter as we expect more longer-dated hybrids being issued next year and you can take your pick when they come to market," he said.

"Our general preference is to stay investment-grade and buy on any weakness, as credit quality is pretty strong overall in Australia."

However, Likos urged investors to tread carefully among non-investment grade issues, as seen with the sudden drop in the issue price of bonds issued by Queensland's Mackay Sugar, amid concerns over its finances.

For investors seeking a diversified approach, Likos pointed to the five-star rated PIMCO Australian Bond Fund [11064] and the four-star rated Nikko AM Australian Bond [10858] as offering "high-quality credit exposure with very transparent, high-quality processes".

"They've proven over a long period of time they can deliver sustainable returns, and while that doesn't guarantee future performance, we have a lot of confidence in their processes and their investment teams," he said.

Looking ahead, Likos said 2018 should be another resilient year for fixed-income investors, although not without its challenges.

"The normalisation process will play out very slowly [overseas] and for that reason credit should continue to perform well. However, should rate increases happen at a greater-than-expected rate, fixed income will come under pressure," he said.

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Anthony Fensom is a Morningstar contributor. This is a financial news article to be used for non-commercial purposes and is not intended to provide financial advice of any kind. Opinions expressed herein are subject to change without notice and may differ or be contrary to the opinions or recommendations of Morningstar as a result of using different assumptions and criteria. The author does not have an interest in the securities disclosed in this report.

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