June Rates Update

Monthly Commentary

July 03, 2017

After nearly a decade of nervously watching the equity market and the steepness of the Treasury yield curve, looking for the first hint of trouble, the FOMC may have attempted to take their first real steps away from the monetary policy punchbowl in June. With Q2 GDP projections and inflation readings headed due south, the FOMC still went ahead with a rate hike at the June FOMC meeting and communicated their comfort in continuing to move the policy rate higher and in tapering balance sheet reinvestment. While the Fed may be comfortable marching the policy rate higher in coming meetings, asset markets are not as sanguine with the idea that tighter monetary policy is necessary in the face of persistently low inflation. Over the course of the month, the Fed’s battle against barely-there inflation helped push the spread between 2y and 10y Treasury yields from 113bps to 82bps, the flattest level seen since 2007.

2 Year-10 Year Treasury Spread

Source: Barclays

Indeed, the FOMC did move the policy rate target another 25bps higher, as expected, at the conclusion of the June FOMC meeting but also unexpectedly announced the notional limits of balance sheet run off to begin later this year. Reinvestment caps will start at $6B/mo for Treasuries and $4B/mo for MBS. They will rise every quarter until the caps reach $30B/ mo for Treasuries, $20B/mo for MBS. This policy action was approved unanimously save Minnesota Fed President Kashkari, who preferred to leave the policy rate unchanged. On the timing of the balance sheet unwind, the FOMC expects to start ‘implementing’ reinvestment changes ‘this year’ if the economy evolves as expected. The plans do not include an ultimate size of the balance sheet or a preferred monetary policy operating framework, but did note that balance sheet run-off would only halt if things were so bad as to warrant a “sizable” reduction in the funds rate.

The FOMC’s cognitive inflation dissidence was also apparent in the updated release of the Summary of Economic Projections, which showed the Fed still believes inflation will reach 2% as soon as next year. The Fed marked up its growth forecast for this year to 2.2% from 2.1% in March. It reduced its forecasts for headline PCE inflation to 1.6% (from 1.9%) and core PCE inflation to 1.7% (from 1.9%). However, the committee continued to forecast 2.0% inflation in 2018 and 2019. The FOMC projects the near term unemployment rate to remain unchanged but did downgrade the long run unemployment rate from 4.7% to 4.6%. The totality of these changes suggests that blind faith in the Taylor Rule is alive and well at the Fed as members expect gains in labor markets to be maintained, helping to push inflation up towards their 2.0% target. The FOMC left the median federal funds rate forecast unchanged relative to March with the median committee member continuing to expect one more hike this year and three next year. While the committee did generally mark its 2017 forecast to market, it was somewhat surprising that the balance of the forecasts including the dots were unchanged.

To close the day’s policy proceedings, FOMC Chair Janet Yellen used her quarterly press conference to identify “one off reductions” in categories “such as wireless services and prescription drugs” as responsible for the recent “noisy” declines in inflation. The market has interpreted this as the Fed now being willing to err on the side of being too tight. Perhaps, this Fed is model driven and is putting a high emphasis on the Phillips curve. However, if realized inflation comes close to the market expectations implied by the TIP market, 1% for Q1 2018, it doesn’t seem plausible the Fed would be hiking given their 2% outlook. Additionally, Chair Yellen provided further guidance to the sequencing of balance sheet operations and hikes, explaining that balance sheet runoff may commence ‘relatively soon’ . In addition, she reiterated that the Fed intends to use changes in the target range for the federal funds rate as the primary instrument of policy in hopes that balance sheet runoff will happen passively “in the background” as if markets are simply “watching paint dry.”

Goldman Sachs Financial Conditions Index

Source: Goldman Sachs

Away from the Fed, other global central bankers have also caught the policy tightening bug in recent weeks, with communications from the ECB and BoE suggesting their respective policies are headed tighter. At a speech at the ECB Forum in Sintra, Portugal, ECB President Mario Draghi said the reflation of the euro-area economy creates room to pull back unconventional measures without tightening financial conditions drastically. This relative hawkishness sent the European rates market into a frenzy with a four standard deviation sell-off in German Bunds on the day. Over the month, the yield on 10y Bunds rose significantly, closing at 46bps from 31bps. Not to be outdone, BoE President Mark Carney hinted that “some removal of monetary stimulus is likely to become necessary”. In his view, in order for the removal of stimulus to become necessary, company investment would need to offset a slowdown in consumer spending. The UK Gilt market responded in kind to this measured move towards a more hawkish stance, with 10y Gilts closing the month at 1.25%, some 25bps higher than where they opened for June.

10 Year Benchmark Yield German Bunds and U.K. Guilts

Source: Barclays

Outside of the fixed income universe, the hawkish rumblings from this who’s who of central banking may have helped cause global equity markets to display bouts of weakness, the likes of which had been few and far between before this month. In the case of the S&P 500, spasms came in the form of two separate 1% intraday drawdowns, which helped turn sentiment toward risk assets negative. What may be most notable about the weakness in equities was the simultaneous selloff in Treasury rates. Traditionally, negative price movements in risk assets like equities are supportive for so called “risk free” assets like Treasuries but that was not the case this month. This break in the traditional linkage suggests that it may be the higher rates themselves that are directly feeding into weakness for risk assets, potentially through one of two channels. The first potential dynamic could be the direct impact that a higher discount rate has on valuation, using a higher discount rate decreases the value of future cash flows making the threshold for investment higher. This relationship is part of former Fed Chair Ben Bernanke’s rationale for the implementation of QE, whereby the central banks drives down discount rates thus lowering the bar for positive NPV investments. The second channel for higher Treasury rates to feed through to equity weakness is via asset allocation. As U.S. rates push higher, the higher yield to maturities on Treasury bonds increasingly becomes a more attractive substitute for risk asset exposure. In either case, current equity sentiment is potentially less bullish than it has been at any time during 2017. Market participants are starting to feel as if the days of having no alternative to equity investments are in the rearview mirror. It remains to be seen if this will ultimately be the case. Despite their grand intentions, global central bankers will have to balance the desire to tighten policy against the impact higher interest rates have on sovereign borrowing costs. With percentages of sovereign debt to GDP soaring, even an extra 25bps here or there may be more deleterious to growth than is currently realized.

As the first half of the year draws to a close, we have seen 10y Treasury yields rally 20bps, the S&P 500 rally nearly 9% and the spread between 2y and 10y Treasuries flatten from 125bps to 90bps. Of course, at the outset of the year market consensus would have told you to expect something different, which suggests that Mr. Market’s ability to find points of maximum pain in asset pricing is alive and well. Expectations for the path forward are less one sided as market participants have started to divide over the expected outcomes of key risk events for the remainder of the year. Whatever the outcome, with all global central banks desperate to head for the door at the same time, we are clearly in uncharted waters.

Source: Bloomberg

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

Note: Each shaded circle indicates the value (rounded to the nearest 1/8 percentage point) of an individual participant’s judgement of the midpoint of the appropriate target range for the federal funds rate or the appropriate target level for the federal funds rate at the end of the specified calendar year or over the longer run. One participant did not submit longer-run projections for the federal funds rate.

Economic Projections of Federal Reserve Board Members and Federal Reserve Bank Presidents Under Their Individual Assessments of Projected Appropriate Monetary Policy, June 2017

Advance Release of Table 1 of the Summary of Economic Projections to be Released with the FOMC Minutes

 

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