March Rates Update

Monthly Commentary

April 04, 2017

March left market participants with more questions than answers as an adjustment to monetary policy and a failed healthcare bill could not break Treasury yields out of recent ranges. Indeed, the FOMC decided to go ahead with another quarter point of policy tightening this month, but did not offer clear guidance on their subsequent policy plans. This policy uncertainty kept investors on the defensive, keeping risk assets and Treasury yields range bound. On the U.S. fiscal policy front, President Trump’s first foray into legislative negotiation yielded mixed results as the Republican effort to repeal and replace the ACA fell short as the GOP could not whip the final 5-10 votes necessary to pass the bill in the House. This confluence of uncertainty from all facets of American policy could continue to cloud the global macro picture and keep the investment community on their collective heels until visibility improves.

Following a whirlwind end-of-February press tour which saw nearly all FOMC members make public statements in support of a March policy tightening, the FOMC pushed the policy rate 25bps higher at the conclusion of their March policy meeting. Despite broad based approval for the rate hike within the committee, Minnesota Fed President Neel Kashkari dissented in favor of an unchanged stance. President Kashkari notwithstanding, the policy statement released following the meeting was reasonably upbeat, voicing a view of an economy expanding at a moderate pace as the labor market continues to strengthen and household spending continues to rise. FOMC members also indicated that they believe inflation is on the right track, suggesting it had increased enough to characterize it as “close to the committee’s 2% target,” adding that they will continue to monitor developments relative to its symmetric inflation goal. While this introduction of the symmetric inflation goal verbiage into the statement was new, the idea of a symmetric inflation goal is something that Chair Yellen and other FOMC officials have stressed many times before. This explicit reference to the symmetric inflation goal is simply a reassurance that the Fed will not react too aggressively if core inflation were to drift somewhat above 2%.

In support of their view that inflation was trending in the right direction but was not yet a cause for concern, the committee boosted the core personal consumption expenditures forecast for 2017 from 1.8% to 1.9% but opted to leave 2018 and 2019 forecasts virtually unchanged. In addition, the median forecast of the fed funds rate, affectionately known was the “dot plot,” for 2017 and 2018 were left unchanged at three tightenings expected for each year. The 2019 forecast was revised upward slightly though, as the median committee member now expects what would equate to 3.5 hikes in 2019 to reach a rate of 3.0% versus December’s 2.875%. Similar changes were made to the long run or terminal rate which is now seen at 3.0% versus 2.9% in December. For the remainder of the committee forecasts, the growth rate was left virtually unchanged with the exception being an increase in the growth forecast for 2018 from 2.0% to 2.1% and a reduction in the natural rate of employment to 4.7% from 4.8%. Remarkably, despite the increase to the federal funds rate Treasury yields and the U.S. dollar both plunged in the aftermath of the FOMC meeting as market participants were looking for a more hawkish message and economic forecast mix than the one they received. Indeed, so pronounced was the asset market reaction that financial conditions eased markedly for the day, effectively undoing the policy tightening the FOMC had just levied.

Roughly half an hour after the statement’s release, Fed Chair Yellen took to the podium for her quarterly post-meeting press conference to deliver additional thoughts on policy. As is frequently the case, the chair delivered an even handed assessment of the economy, opining that monetary policy was still accommodative but the FOMC was closing in on their inflation and employment mandates. The Chair was also vague on the future prospects for balance sheet normalization, but did indicate that whenever they were ready to get balance sheet reduction the process would be both gradual and predictable. Furthermore, Chair Yellen once again declined to provide any specific comments pertaining to the new administration or potential policy responses to any fiscal stimulus but did indicate some FOMC participants have “penciled in” fiscal adjustments.

While Chair Yellen and her colleagues were planning the next steps for monetary policy, their fiscal policy counterparts on Capitol Hill were at work drafting a healthcare bill to replace the Affordable Care Act. Since the ACA became law in 2010, House Republicans have voted to repeal it 59 times but never got the chance to offer their own alternative. When finally given the opportunity to present a law of their own this month, the bill failed to make it to the House floor as Republican Party members could not agree on some of the legislation’s finer points. Although President Trump’s decision to tackle health care as his first major policy initiative may seem questionable, it remains an important first step towards large scale tax reform. Without replacing the ACA with something cheaper, President Trump will have a more difficult time passing meaningful legislation due to Senate rules and CBO scoring criteria. Along those lines, there were nearly $600bn in tax cuts in the healthcare repeal effort financed by significant reductions in Medicaid outlays. Without the Medicaid cuts to “pay for” this lost tax revenue, it will be hard for President Trump and Speaker Ryan to produce a tax reform plan of the originally planned $3tn size that will be deficit neutral beyond a 10y horizon.

As the first quarter of the year draws to a close, investors are still left without clear guidance on the future policy tightening path for the FOMC or what to expect from the Trump administration. If the FOMC is to be believed, it would appear their modal outcome for 2017 is three policy tightenings with a risk that as many as four hikes may be realized. However, given the market’s reluctance to price in more than 2.5 or so tightenings for the year, it appears investors will force the Fed to actually make good on their forecasts for once before making any major changes in investment stance. Similarly, it appears as if the initial “Trump Trade” euphoria has died down and any further gains will most likely have to come as a result of delivered results and not intended progress. Regardless of whether the bull or bear case is delivered, global asset markets remain in “show me” mode suggesting sideways price action could continue until concrete progress is made in one direction or another.

Source: Bloomberg

TSY Yield Curve Across Maturities

Source: Barclays Live

Source: The Federal Reserve

Source: The Federal Reserve

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