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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