Ken Taubes is Chief Investment Officer, US.
The Tug of War Between the Markets and the Fed Continues: Will the Fed Prevail this Time?
With the path of future rate hikes, the tapering of the Federal Reserve’s (Fed’s) balance sheet, growth and inflation, views all in play, the Federal Open Market Committee’s (FOMC’s) June 13-14 meeting represented a key event for markets; the Fed did not disappoint. As expected, they voted 8-1 to move forward with a 0.25% rate increase, despite recent softening in inflation and first-quarter US GDP growth. But, their outlook for the future was more hawkish than expected, and at odds with what the market has priced in, especially on the heels of May’s lower CPI report.
FOMC members held firm to their projections for one additional rate increase in 2017, and three hikes in 2018, citing solid GDP growth and job gains. While acknowledging that inflation may not meet their 2% target in 2017, the Fed believes that inflation will increase to target levels by 2018. Also surprising was the level of detail contained in their separate discussion of the balance sheet; they confirmed they would begin balance sheet reduction in 2017.
All told, we believe that the markets remain “behind the curve” in their views on the appropriate level of interest rates. With its more hawkish statement, the Fed may have recognized that it, too, has been behind the curve, and may be resolved on getting back to neutral. Both growth and inflation have generally met the Fed’s goals, in a situation in which we are facing full employment. Moreover, despite a delay in the implementation of Trump’s pro-growth tax cuts and increased infrastructure spending, GDP growth may strengthen through 2017, buoyed by strong global growth, easy financial conditions and lower regulation.
Under these circumstances, we do not believe US short-term real yields should be negative, and we find little value in short-term Treasuries. We also believe the Fed’s balance sheet normalization can be used to help manage the longer end of the yield curve, and avoid the potential for a yield curve inversion that could result from a sole focus on raising short-term rates. While a barbelled yield-curve position (overweight in short- and long-term bonds while underweight medium-term bonds) makes sense for fixed income investors in a rising rate environment, we prefer some moderation of this position, in light of the Fed’s potential adjustment to balance sheet positions in longer-duration Treasuries and mortgage-backed securities (MBS).
Views on Growth, Inflation and Employment
The FOMC statement and Chair Janet Yellen’s press conference emphasized the rebound in economic growth from the first quarter. Yellen cited strong household spending and improving fixed investment, underpinned by consumer confidence, significant gains in household wealth, and stronger global growth. In addition, the continued decline in unemployment and the higher participation rate are supportive of rate increases. The most recent retail report showing a 4.3% annualized gain over the past three months further bolsters the Fed’s positive outlook. Total real consumption, including services, rose at a 3.8% annual rate in the second quarter, up from the 0.6% change in the first quarter.
Inflation Outlook: Fed Maintains Medium-Term View of Inflation?
The most controversial part of the FOMC minutes is that the Committee maintained its medium-term view of 2% inflation. While the FOMC economic projections showed a 0.3% decline in inflation to 1.6% at the end of 2017, the forecast remains at the 2% target by 2018. Yellen highlighted “one-off, idiosyncratic” factors of price cuts for wireless services and prescription drugs that reduced core inflation in March, saying those effects will roll off in 2018. Indeed, some have estimated that each of these factors may have reduced inflation by almost 0.20%. Yellen also referred to the stability of inflation forecasts from the Survey of Professional Forecasters, and the minutes noted “little” change in longer-term inflation expectations. We favor the Fed’s view of inflation and believe that the market, which is now pricing in only a 46% chance of a December rate hike, is underestimating potential inflationary pressures.
A central part of the debate regarding inflation is that the recent sharp decline in the unemployment rate (which the Fed did not foresee) has not been accompanied by rising wage costs. Instead, wage inflation has declined over the past three months, as measured by average hourly earnings. Yellen acknowledged the significant flattening of the Phillips curve and the difficulty in estimating the neutral employment rate. This view may have led the FOMC to reduce its projection of the neutral rate of unemployment from 4.7% to 4.6%, as they also reduced their projection of the unemployment rate from 4.5% to 4.3% in 2017 and to 4.2% in both 2018 and 2019. Yellen continues to be convinced, however, of the validity of the relationship between employment levels and broad inflation. She also argued that employment indicators, including several components of the JOLTS Index (Job Openings and Labor Turnover Survey), indicate tight labor markets, supporting her view that wage inflation would rise. Yellen noted that the Personal Consumption Expenditures Index has increased from 1% a year ago, to 1.7% today. We would observe that wage inflation is grinding tighter; as measured by the Employment Cost Index, wage inflation has risen over the year through March from 1.9% to 2.4%.
Modest Changes for Rates and Terminal Funds Rate
Apart from 2017 inflation and the unemployment rate, the FOMC’s economic projections showed very modest changes from March levels. The median view for the Fed Funds rate was unchanged for 2017 and 2018, with only a 0.1% decline to 2.9% in 2019; the neutral rate remained at 3%. When Yellen was challenged on the unchanged terminal Fed Funds rate, she acknowledged that the current neutral rate may be lower,but she anticipated the rate would rise as growth, inflation and the term premium normalized.
Fed to Proceed Slowly and Transparently in Reducing Balance Sheet
The degree of specificity with respect to balance sheet normalization suggests that the Fed may begin the program fairly soon, possibly in September. With the stark memory of the 2013 “taper tantrum” sell-off in mind, the Fed indicated its intention to proceed slowly and transparently in reducing its balance sheet. In a separate addendum to its statement, the FOMC agreed to cap balance sheet reductions at $10 billion per month while rising by $10 billion in three-month intervals until they have reached $50 billion per month within one year. US Treasuries reductions will begin at $6 billion per month, rising by $6 billion every three months, to be capped at $30 billion per month within one year, while Agency MBS reductions will begin at $4 billion per month, rising by $4 billion in three-month intervals, to be capped at $20 billion per month within one year. Yellen further indicated that balance sheet management should not be viewed as an active tool of monetary policy, and that she would rely primarily on the Federal Funds target rate for that purpose. We believe the Fed’s ownership of longer maturity Treasuries provides the added benefit that they can help manage the longer end of the yield curve, and avoid the negative outcome of an inverted yield curve.
We were encouraged by the more hawkish stance of the Fed, in light of our view that US yields do not fairly reflect prospective levels of economic activity and inflation. Although Trump’s pro-growth policies may have more impact in 2018, we believe the reduced regulations that President Trump has enacted through executive orders are already contributing to economic growth. In addition, continued strong consumer sentiment, easy financial conditions and strong global growth may support 2017 GDP growth. The Fed seems to be making good on its goal to normalize rates and reduce the potential for asset bubbles, as well as its mandates to foster full employment and maintain price stability.