December Rates Update

Monthly Commentary

January 12, 2018

After final review, it is remarkable what an unremarkable year 2017 was in global rates. Despite three consecutive quarters averaging about 3% GDP, a 6/10th drop in the U-3 rate, six consecutive CPI misses, and three Fed rate hikes, 10 year Treasury yields finished 2017 a mere 7 bps higher than where they began the year at 2.40%. Narrow ranges and low volatility persisted across sovereign benchmarks in 2017 as the Japanese 10 year note unsurprisingly took the top spot for narrowest range at 16 bps, followed by Bunds at 46 bps, France at 58 bps, Gilts (UK) at 60 bps, USTs at 61 bps, and BTPs (Italy) at 65 bps. While it would be difficult to boil all of 2017 down to a single chart, the collapse in 10 year 3 month volatility graphed against the loosening in Chicago Fed Financial Conditions Index illustrates the volatility selling/curve flattening regimen seen all year.

U.S. Treasury Market Overview

Source: Bloomberg Barclays

10 Year 3 Month Normalized ATM Volatility vs. Goldman Sachs U.S. Financial Conditions Index

Source: Bloomberg Barclays

The most notable monetary policy event in December was FOMC Chair Janet Yellen’s decision to raise the policy rate another 25 bps to 1.25%-1.50% in her final meeting as chair. This policy action came with two dissents, one from Minnesota Fed President Kashkari and the other from Chicago Fed President Evans who preferred to take no policy action. These dissents were somewhat expected, but more importantly neither of these regional bank presidents will be voting members of the FOMC in 2018. In terms of the FOMC statement, commentary around economic activity remained upbeat with upgraded language about the labor market saying it is expected to “remain strong” rather than “strengthen somewhat further.” On inflation, the policy statement was a carbon copy of the prior meeting’s commentary save a change in the current conditions paragraph, which no longer characterizes core inflation as “soft.” This is a very small change but it is a touch more hawkish than previous statements.

For the Summary of Economic Projections, the FOMC now projects the labor market to remain strong with a lower unemployment rate of 3.9% and stronger GDP growth across the forecast horizon, particularly next year where growth is expected to be 2.5% (vs. 2.1% previous), likely due to the recently enacted federal tax cuts. Despite these positive revisions, the Fed’s forecast for core inflation and the dot plots are largely unchanged, with median expectations of three more hikes in 2018 and CPI of 1.9% in 2018 and 2.0% in 2019 and 2020. The 2020 dot was revised slightly higher to reach 3.06% from 2.875%, an increase of almost one full hike.

Federal Reserve Open Markets Committee Policy Rate Forecast

Source: The Federal Reserve

The fixed income market rallied following the release of the FOMC statement and during Chair Yellen’s press conference, as many market participants seemed to take the combination of a sizeable upgrade to the growth numbers and no upward movement in the 2018 and 2019 dots as an indication that the FOMC has now mostly accounted for the impact of the tax cuts, but did not feel that their impact warranted additional tightening, at least over the next two years. However, it is quite possible that FOMC members would prefer to see the realized impact of the now passed tax cuts before recalibrating their own forecasts. Regardless of view, it seems unwise to put too much weight on projections from a lame duck FOMC Chair and a policy voter base that will be largely different in 2018.

2 Year Yield Around Statement Release and Press Conference

Source: Bloomberg, Goldman Sachs Global Investment Research

And yes, December finally saw the passing of the well-discussed Republican led tax reform bill. While we will have to reserve comment on the actual, realized impacts of this bill for another monthly update, there were some clear takeaways in terms of changes from current law that can be interpreted immediately. For financial market participants, the decrease in the corporate tax rate from 35% to 21% is the most interesting feature of the bill. The significantly lower tax rates will serve to push earnings higher but how this earnings windfall is spent will be paramount in determining the knock-on impact of the bill. If corporations are content to use profits to buy back shares or debt, then the bill will only be a temporary stimulus on equity or debt prices. However, if the higher profitability leads to increased capital expenditures we could see a non-trivial boost to domestic GDP growth in addition to any boost to share prices. Potentially the second most market moving feature of the tax bill will be the new rules around the repatriation of earnings abroad. Under the new legislation, earnings abroad accumulated since 1986 would be repatriated back to the U.S. at a tax rate of 8% and liquid earnings would be taxed at 15.5%. Repatriation is expected to raise $339 billion over 10 years. This repatriation could potentially spark a round of USD buying as U.S. corporations bring back cash from overseas. It remains unclear if this will have a meaningful impact on the USD because whether or not U.S. corporations need to buy USD is dependent on whether or not this overseas cash was already invested in a U.S. asset. If that is generally the case, the impact on the dollar could be fairly muted.

As 2017 draws to a close, we could not have a more interesting market backdrop going into 2018. We are at record low levels in volatility, record high equity prices, and amongst the tightest High Yield spreads seen in the last 20 years. That is not to say this unprecedented calm cannot persist, and it may, but asset prices have seldom moved in a straight line for this period of time without something unforeseen happening. However, it is just that sort of thinking that could see risk assets continue to climb the wall of worry. If market participants decide that risk assets still look attractive on a relative basis to the risk-free rate despite having questionable-at-best outright valuations, there is potential that the market could press higher still. Regardless of which outcome manifests itself, 2018 will most likely secure its place in market history books.

Federal Reserve Open Markets Committee Summary of Economic Projections

Source: The Federal Reserve


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