March Rates Update

Monthly Commentary

April 01, 2016

Relative calm returned to the markets in March as global central bankers worked to assuage fears that they were out of tools in their monetary policy toolkit. To that end, they were fairly successful as oil recovered to close the month at $39/ barrel while the SPX rallied towards 2050. However, global fixed income yields continued to trade with a bullish bias on downward revisions to global growth and inflation forecasts. In the U.S., this yield rally was led by shorter maturity treasuries as the yield curve between 2y Treasuries and 30y Treasuries steepened on FOMC dovishness. Interestingly, the Citi Surprise Index for U.S. economic data continued higher reflecting better than consensus data in the month of March. However, this may simply be a function of data improving on a relative basis to expectations as opposed to outright.

The European Central Bank (ECB) kicked off the month’s central bank meeting schedule by announcing major additions to their current easing package. It was clear ECB President Mario Draghi did not intend to repeat December’s market disappointment as he exceeded market expectations on most fronts. Not only did the ECB cut the deposit rate to -40bps and increase monthly purchase in their asset program to $80bln, they also announced investment grade euro-denominated bonds issued by non-banks would be eligible to be included in regular asset purchases. Maybe most notably, the ECB also announced a series of four longer term refinancing operations (TLTRO II) which could possibly pay European banks up to 40bps a year over four years to borrow money. The ability to pay banks up to almost half a percent a year to borrow is potentially a quite powerful tool, however it remains to be seen if the banks can be incentivized to borrow at any price as long as European loan demand remains anemic. In spite of this move toward further expansionary monetary policy, the spread between German 2y and German 10y government continued to flatten, suggesting the market isn’t convinced that President Draghi’s newest maneuver will bolster demand or inflation. This continued flattening also may be related to President Draghi’s press conference comment in which he stated that he did not expect the ECB deposit rate to be cut further. If this is indeed the case and the ECB no longer views deposit rate cuts as beneficial, it will be up to the domestic economy to generate growth via credit demand as opposed to using rate cuts to gain a trade advantage via the currency.

Despite their European colleague’s decision to expand monetary policy further, the Bank of Japan (BoJ) voted to leave their monetary policy unchanged this month in the face of further deterioration in domestic economic data. This deterioration in the domestic economy did not go unnoticed in the BoJ’s policy statement which described prior improvements in exports and housing as having “stalled.” After cutting rates into negative territory the prior meeting, it appears as if the BoJ prefers to monitor developments of their policy change as opposed to increasing stimulus. However, if the recent Q1 GDP reading of -1.1% YoY is any indication, they will not be able to stay on hold much longer if demand and inflation expectations continue to fade. Nowhere has this lack of Japanese demand and inflationary pressure been more apparent than in the yield of the 10y Japanese Government Debt which currently yields -1bps, a far cry from the 27bp level at which they traded at the beginning of this year. After closing lower in yield for the month of March, 10y JGB yields have closed lower on a month over month basis eight of the last nine months, suggesting that this latest wave of decreased demand is already well entrenched in market sentiment.

The anchor leg of this month’s monetary policy trifecta was run by Janet Yellen and the FOMC, who kept policy unchanged at their quarterly “press conference” meeting. Despite having prepared the market for no change in policy, the dovishness of the statement and economic projections caught market participants off guard. This lack of preparation for such a dovish message was quite evident in the 14bp rally in December 2016 Eurodollar contracts. In the statement, the committee upgraded its assessment of economic activity. In their view, activity has been expanding at a moderate pace driven by moderate household spending, an improved housing sector, and a further strengthening in the labor market. Conversely, they highlighted business fixed investment and exports as softening. While their commentary on the domestic economy was somewhat mixed, their evaluation of the global economy was decisively negative as the FOMC judged that global financial developments posed significant risks to their outlook. The damage done to the outlook in the near term was reflected in the Staff Economic Projections, which showed slight downward revisions in projections for 2016 GDP growth and PCE. Most surprising, however, was the reduction of the median 2016 and 2017 fed funds projections by 50bps each to 0.875% and 1.875% respectively. In meetings past, downward revisions to the fed funds projections have generally matched the magnitude of downward revisions to economic forecasts. However, in this instance there was a significant discrepancy between the size of downward revisions between the two, suggesting that the Fed may be moving towards a view that sees the suppressed level of real rates as structural as opposed to cyclical.

Remarkably, following Chair Yellen’s dovish turn at the March FOMC press conference, several of her FOMC colleagues spoke out in disagreement against current Fed policy. Indeed, Philadelphia Fed President Harker, San Francisco Fed President Williams, Atlanta Fed President Lockhart and Chicago Fed President Evans all voiced their support for tightening policy further sooner rather than later, in the weeks following the meeting. The most surprising hawkish turn was that from Chicago Fed President Evans, an über dove and a staunch supporter of keeping policy easy until realized inflation moved meaningfully and sustainably higher. These public challenges to Chair Yellen’s economic views briefly brought the implied probability of a June tightening near 50% despite Q1 2016 GDP tracking well below 2%.

Against this mini revolt, the Chair took to the podium at the Economic Club of New York towards the end of the month to reaffirm the FOMC’s commitment to leaving policy quite accommodative in support of the domestic economy. Similar to her March FOMC press conference, the Chair emphasized that fallout from abroad made interest rate policy asymmetric in such close proximity to the zero bound. Surprisingly, the Chair also acknowledged that R*, the short term equilibrium real rate, could be 0% or below. Assuming a 2% inflation target, if R* is indeed 0% then the implied fed funds terminal rate is 2%. Furthermore, if R* is closer to -1.25% as the Chair suggested, the corresponding terminal rate would sit near 75bps or just 2 hikes away from current levels. The extreme overarching dovish tone of the speech threw cold water on the potential for a June hike as the market implied probability plunged towards 20%. Of course, the future path of the U.S. economy is uncertain; but this speech may eventually be seen as the first step towards aborting the current hiking cycle or at least taking an extended pause.

Potentially, one of the most important knock on effects of this renewed dovish FOMC fervor has been the 4% decline in the trade weighted U.S. dollar index this month. Since the beginning of its 25% rally in mid-2014, the dollar has wreaked havoc on the earnings of multinational firms, the U.S. manufacturing sector and the commodity complex. Now that the FOMC has guided down hiking expectations significantly, the premium assigned to the dollar because of the expected Fed hiking path should dissipate somewhat so long as other central banks keep their own policy on hold. However, further interest rate focused easing from the BoJ or ECB could reignite a dollar rally because of the wide differential between short term U.S. rates and other short rates globally. Unfortunately for the FOMC, it does not appear policy divergence is currently possible to the degree which they originally hoped as it seems the U.S. may be coming down with the same cold it gave the rest of the global economy when it sneezed in 2008.

Source: Bloomberg

Bloomberg Trade Weighted Dollar

Source: Bloomberg

Annual Growth of Monetary Financial Institution Loans to Non-Financial Corperations

Source: Bloomberg

Economic Projections of Federal Reserve Board Members and Federal Reserve Bank Presidents Under Their Individual Assessments of Projected Appropriate Monetary Policy, March 2016

Source: The Federal Reserve

Projections of change in real gross domestic product (GDP) and projections for both measures of inflation are percent changes from the fourth quarter of the previous year to the fourth quarter of the year indicated. PCE inflation and core PCE inflation are the percentage rates of change in, respectively, the price index for personal consumption expenditures (PCE) and the price index for PCE excluding food and energy. Projections for the unemployment rate are for the average civilian unemployment rate in the fourth quarter of the year indicated. Each participant’s projections are based on his or her assessment of appropriate monetary policy. Longer-run projections represent each participant’s assessment of the rate to which each variable would be expected to converge under appropriate monetary policy and in the absence of further shocks to the economy. The projections for the Federal funds rate are the value of the midpoint of the projected appropriate target range for the federal funds rate or the projected appropriate target level for the federal funds rate at the end of the specified calendar year or over the longer run. The December projections were made in conjunction with the meeting of the Federal Open Market Committee on December 15 – 16,2015.

  1. For each period, the median is the middle projection when the projections are arranged from lowest to highest. When the number of projections is even, the median is the average of the two middle projections.
  2. The central tendency excludes the three highest and three lowest projections for each variable in each year.
  3. The range for a variable in a given year includes all participants’ projections, from lowest to highest, for that variable in that year.
  4. Longer-run projections for core PCE inflation are not collected.

FOMC Participants’ Assessments of Appropriate Monetary Policy: Midpoint of Target Range or Target Level for the Federal Funds Rate

Source: The Federal Reserve

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