The Fed, Going Forward

Viewpoints

March 23, 2017

In 2015 and 2016, the Fed waited until December to get in the first and only hike of both years. In 2017, the Fed has already hiked once by March. What is the rest of the year likely to bring?

Expect Multiple Hikes This Year (Seriously This Time)

The effective Federal funds rate still remains well below even pessimistic expectations of the short-term equilibrium nominal interest rate (r* + inflation). If the short-term real interest rate (r*) is 0%, and the inflation target is 2%, the neutral Federal Funds rate projects to 2%. Despite having gotten in three quarter-percent hikes off the 0.25% level, the current Federal funds target rate at 1% remains 100 basis points accommodative to 2%. Thus, one can argue that the Fed is not so much aggressively tightening monetary policy as they are making monetary policy slightly less accommodative.

The stated reason for the Fed’s newfound determination to raise rates is that the economy continues to progress toward its dual mandate. The labor market continues to tighten as the U.S. economy creates roughly 200,000 jobs per month. Inflation is also trending higher, with headline inflation rising due to base effects of oil and core inflation prints (ex-food and energy) finally approaching 2%. Thus, the Fed can continue hiking rates for price stability while still promoting full employment.

Many FOMC members have publicly reinforced this hawkishness by stating they expect to hike at least three times this year, yet Chair Janet Yellen’s opinion matters most. Yellen’s own “optimal control” theory postulated that rates should be kept lower for longer to ensure a stronger recovery, but then ultimately raised more aggressively once tightening begins to make up for this easier period. Have we finally entered this more aggressive tightening period? Like in a poker game, one must read the player and not the cards. The key is to understand Yellen’s thinking.

Yellen is Already Thinking of Her Legacy and Acting Accordingly

With less than one year until her chair term is up and she is likely replaced by President Trump, Janet Yellen’s recent speech “From Adding Accommodation to Scaling It Back” had the feel of an outgoing chair looking to defend her legacy. After detailing lengthy (and some might say dubious) explanations as to why the Fed only hiked once in 2015 and 2016, she implied that in 2017 the Fed is more resolute to proceed on its intended hiking path, or in her words, “the process of scaling back accommodation likely will not be as slow as it was during the past couple of years.”

Going inside the mind of Janet Yellen, the primary criticisms she has faced during her reign as Fed chair have been her unwillingness to normalize interest rates and her reluctance to shrink the balance sheet. If Mrs. Yellen wants to give herself the best odds of being remembered more fondly in the history books, she needs to address these concerns before her chair term ends. Getting in a couple of rate hikes and announcing a schedule for commencing balance sheet reduction before the end of the year would do just that, even though many will still claim it is too little, too late.

If there are unforeseen economic shocks or fiscal policy breakdowns during the year, then this course of action can quickly change, but assuming the status quo, the Fed’s trajectory appears largely set. Announcing balance sheet reduction before leaving would also invoke strong similarities to Ben Bernanke’s exit as chair when he announced the tapering of asset purchases in his final month before leaving his successor (Yellen) to handle the logistics of executing the plan.

The Pending Transition from Rate Hikes to Balance Sheet Reduction

The Fed’s balance sheet currently sits at $4.5 trillion. Prefinancial crisis it was less than $1 trillion. The balance sheet expanded through Treasury and mortgage-backed securities (MBS) purchases, which materially increased risk asset pricing through the portfolio balance channel. With the Fed now looking to remove extraordinary monetary policy accommodation, it makes sense to reduce the balance sheet.

Yet, if expanding the balance sheet was seen as an alternative to cutting rates at the zero lower bound, shrinking the balance sheet must be similarly seen as an alternative to hiking rates. Balance sheet reduction represents a secondary monetary policy brake pedal, with traditional rate hikes being the primary brake pedal. When the Fed transitions to reducing the balance sheet, it may temporarily pause on rate hikes to prevent from pushing two brake pedals simultaneously.

Numerous Fed officials have hinted towards such thinking. Minnesota Fed President Neel Kashkari dissented against hiking in March in favor of alternatively announcing a schedule for balance sheet reduction and seeing how the market digested it. Yellen, herself, postulated in a footnote to a recent speech that the monetary policy tightening impact of reducing the balance sheet may be equivalent to two rate hikes. Finally, Philadelphia Fed President Harker declared in January that “when [the Fed funds rate is] at or above 100 bps, I think it is time to start serious consideration the first stopping of reinvestment and then over a period of time unwinding the balance sheet.”

Scars from the market taper tantrum of 2013 have led the Fed to telegraph monetary policy actions well in advance to prepare the market. The constant harping on balance sheet reduction by committee members in public speeches signals that action is imminent, and the inherent cautiousness of the Fed implies it will likely temper concurrent rate hikes. Expect balance sheet reduction to be announced later this year and initiate with stopping MBS reinvestment as mortgage spreads are tight, the housing market is strong and MBS securities were not traditionally a part of the Fed’s balance sheet.

Investment Implications:

If Fed balance sheet expansion lifted risk asset pricing, then balance sheet reduction should reduce risk asset prices. Yet, monetary policy is no longer the only game in town as fiscal policy stimulus and geopolitical concerns are now in play amid what appear to be late-cycle economic dynamics.

From a U.S. rates perspective, Chair Yellen’s legacy concerns and corresponding hawkishness would traditionally bias front-end rates higher as more hiking expectations are priced in. Yet, the pending transition to balance sheet reduction should temper the extent to which the Fed will hike rates.

The market is currently pricing in just less than two additional hikes in 2017 and two hikes in 2018. If this pace materializes, the front-end of the rates curve is fairly priced despite optically low outright yield levels. Front-end rates valuation is driven by positive carry and roll down the curve, as they provide a natural buffer against higher yields within a fixed income portfolio.

The forward rates curve is also very flat, which shows that the market has already priced in higher front-end rates in the future. Investors should only avoid front-end duration if they expect rate hikes to be materially greater than what the market has already priced into the forwards.

For example, the 2s10s Treasury curve is projected to flatten 60 bps over the next 2 years from 115 bps to 55 bps. This is due to the forwards projecting the 2-year rate to rise 107 bps from 1.25% to 2.32%, while the 10-year rate only rises 47 bps from 2.40% to 2.87%:

Duration in fixed income portfolios need not be shunned simply because the Fed is hiking. A perfect example of this was shown last week, when the Fed hiked and rates rallied 10 bps across the curve. In a low yield environment, duration must be analyzed by comparing underlying carry and rolldown dynamics against hiking expectations already been priced into the implied forwards.

Conclusion:

To understand the Fed in 2017, realize that Janet Yellen is looking to defend her legacy as chair. This cover-your-tail philosophy entails a more hawkish response function. Yet, the transition to balance sheet reduction will temper the number of traditional rate hikes, as balance sheet reduction represents an unknown monetary policy tightening avenue. In 2018, President Trump’s pending appointments to the board will shape future Federal Reserve policy direction. Yet, for the remainder of this year, Yellen has revealed an inclination to make up for lost time. While the kneejerk reaction is to short duration, investors should closely examine carry and forwards to optimally invest fixed income portfolios.

Source: Bloomberg

 

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