Update on the Federal Reserve System and interest rates below 07:26.17 at 3:20PM EST
In the note below, Chief Market Strategist Brett Ewing of First Franklin reacts to today’s Fed announcement.
He says in part, “We believe that both the market and the Federal Reserve System will be much more concerned with how the balance sheet normalization will go and we expect the Fed to begin the normalization sometime before the end of the year.”
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He further says, “If the Fed can get the unwind off and running successfully without upsetting markets we expect Janet Yellen to step down as Fed Chair and Gary Cohn to take over in 2018.”
The Fed continued its policy of not upsetting the apple cart when they didn’t give a press conference to explain things.
We believe that both the market and the Fed will be much more concerned with how the balance sheet normalization will go and we expect the Fed to begin the normalization sometime before the end of the year. It will likely use the remaining two press conferences to focus on questions the market may have.
If the Fed can get the unwind off and running successfully without upsetting markets we expect Janet Yellen to step down as Fed Chair and Gary Cohn to take over in 2018.
The weak dollar continues to put the Fed in a goldilocks environment where the market isn’t concerning itself with rates. And we don’t think there will be a rate hike until 2018; that’s the most likely scenario. Although December 2017 is in play, but still is less than 50 percent chance.
We expect the yield curve to steepen as we move toward the end of 2017.
Outlook for US Markets Amid Earnings
The dollar weakening so quickly and leading to a global recovery – coupled with the fact that the dollar was so strong this time last year – will lead to a nice earnings growth number simply because we are going up against weak comps on a year-over-year basis.
We are more interested in the second half of the year where comps aren’t as easy, although admittedly if the dollar stays down, growth will be just as good.
View on Health Care Bill
Congress failing to get something done that they promised to do is not anything new to the markets. We doubt it will have much of an effect.
The fact is that most large healthcare providers and drug companies probably prefer congress doing nothing to something being done and those companies are what investors are actually investing in.
To that point there is plenty of data out there to suggest that political discourse is actually a positive for stock market performance.
Current Investment Strategy
On the debt side, we continue to prefer to take risk on the corporate credit side (as we believe balance sheets are strong even in some non-investment grade companies), more so than on more rate sensitive instruments.
We think there are opportunities in the mortgage space, specifically in MSRs as refi risk is diminishing and companies offering PMI with – as we see it – limited downside in residential RE. We also believe the CMBS side is relatively solid despite some concerns over the retail sector and some 2012 vintages coming due and being weak. When the next crisis comes we don’t believe real estate will be involved because that was the last crisis and people are hyper focused on making sure it doesn’t happen again.
On the equity side, we would overweight international stocks – specifically emerging markets – as we continue to believe we are finally in a global recovery and no longer in a world where the US Markets just prop everything else up—watch the dollar strength for signs the trade has run its course.
Domestically, we are a firm that tends to take individual positions in small caps where we believe we have identified some special situation for which the market isn’t properly accounting. We continue to believe that despite some valuations being stretched – mostly because of the boom in passive ETF investing – we are finding plenty of opportunities in securities that are outside of these indexes that haven’t been discovered and properly valued by markets.
UPDATE 11:29AM EST on 6/15/2017 on the Federal Reserve System, rates and data
In her note below, Chief Economist at Stifel Fixed Income, Lindsey Piegza, Ph.D., offers insight on yesterday’s Fed Rate Hike, Global Central Bank Policy and the Russia Probe.
In part she says, “modest labor market gains and cooling inflation, appears to be the missing component that would normally be at the forefront of an accelerated rate path.”
See below for Piegza on the Federal Reserve System
Fed Hikes Rates Despite “Soft” Inflation; Global Central Bank Policy; Russian Probe Extended
Yesterday, the Fed opted to raise rates for the third time in six months, increasing the Federal funds rate from 1.00% to 1.25%.
Bottom Line: On the heels of additional “soft” inflation data released this week, the Fed’s decision to move forward with a second-round increase this year appears to be motivated by both a push from the market with yesterday’s rate hike fully priced in, according to Bloomberg, as well as a desire to rebuild the monetary policy tool kit. Justification from the data, on the other hand, as the economy shows lingering signs of weakness carrying over from the first-quarter amid still-sluggish consumer activity, modest labor market gains and cooling inflation, appears to be the missing component that would normally be at the forefront of an accelerated rate path. In other words, the Fed’s decision to raise rates on Wednesday, while expected, appears to be little motivated by the data but rather unfounded optimism, leaving the future pathway for rates even more uncertain at this point.
Other central bank policy adjustments this week: despite further action from the Fed, the People’s Bank of China left interest rates unchanged at the June 15th meeting. The rate for the 7-day reverse repo remained at 2.45%, the 14-day reverse repo at 2.60% and the 28-day reverse repo at 2.75%. Previously in March, mirroring the Fed’s decision to hike rates, the PBOC opted to raise rates on the 7-day, 14-day and 28-day repos.
The Swiss National Bank also held rates unchanged at today’s meeting citing a “multitude of political uncertainties.” The SNB opted to maintain negative rates, keeping its deposit rate at -0.75% as it has since January 2015.
In her note below, Chief Economist at Stifel Fixed Income, Lindsey Piegza, Ph.D., offers insight on today’s from the Federal Reserve System decision to raise rates despite support from data and to rebuild the monetary policy tool.
In part she says, “the Fed’s decision to move forward with a second-round increase this year appears to be motivated by both a push from the market with today’s rate hike fully priced in … [and] a desire to rebuild the monetary policy tool kit.”
As expected, the Fed opted to raise rates 25bps, from 1.00% to 1.25%. This is the second increase in 2017 and the third in the past seven months.
Bottom Line on the Federal Reserve System: On the heels of additional “soft” inflation data released this week, the Fed’s decision to move forward with a second-round increase this year appears to be motivated by both a push from the market with today’s rate hike fully priced in, according to Bloomberg, as well as a desire to rebuild the monetary policy tool kit. Justification from the data, on the other hand, as the economy shows lingering signs of weakness carrying over from the first-quarter amid still-sluggish consumer activity, modest labor market gains and cooling inflation, appears to be the missing component that would normally be at the forefront of an accelerated rate path. In other words, the Fed’s decision to raise rates today, while expected, appears to be little motivated by the data, leaving the future pathway for rates even more uncertain at this point. Acknowledgement of the recent decline in prices within the statement as well as with a modest downward revision to the forecast, however, appears to be taking a backseat to the Fed’s general optimism for improvement in growth and inflation. Without sizable and clear additional weakness, the Fed appears steadfast in their commitment to one additional rate hike this year. Once again, the Fed’s credibility is on the line as the data argues for quite an opposite position.
Federal Reserve System – more commentary from analysts.
Below are comments from Jeremy Lawson, Chief Economist at global asset manager Standard Life Investments (SLI), regarding the Federal Reserve System today.
SLI manages $350 billion and is merging with Aberdeen Asset Management. The new entity, once complete, will be one of the largest active managers in the world.
“On balance I see this as a modestly hawkish surprise relative to market expectations heading into the meeting.
Despite the 3mth annualised growth rate of core CPI inflation dropping to zero after today’s data, the Committee’s only substantive reaction was to downgrade its end year core PCE inflation forecasts by 0.2ppts.
Otherwise, the median 2018 and 2019 core inflation forecasts were unchanged, the median policy projections for 2017 and 2018 were unchanged (1 more rate hike this year, 3 next year) and the FOMC is still signalling that balance sheet normalisation will begin before year end. Yellen’ press conference was also fairly dismissive of the view that the recent inflation disappointments contained much of a signal.
Federal Reserve System – Philips curve believers?
This is therefore still a Committee that has faith that the Phillips Curve will reassert itself in the medium term. While the Committee is right to be doubtful that the extent of the recent weakness in core inflation prints will be sustained, their confidence in the timing and speed of the pick-up will be tested over the coming months.
With regard to the balance sheet, the FOMC was quite explicit about its intended path, issuing an additional communication document to set out their new exit principles. They will begin with a cap on Treasury security runoff of 6bn a month and a cap of 4bn a month on MBS runoff. That will increase in 6bn and 4bn increments respectively every 3 months until maxing out at 30bn and 20bn after 12 months. That implies that by end 2018 the balance sheet will be dropping by 50bn per month in those months where maturation is running at that pace, or an annualised rate of 600bn.
That implies that the Fed will get down to its target balance sheet size faster than I anticipated, unless a recession occurs in the meantime. The FOMC also made it clear that the federal funds rate will be the main policy instrument during normalisation, though a substantial negative shock that forced it to cut the federal funds rate would cause it to recommence reinvesting maturing securities.
The open question coming out of the meeting is whether the Fed’s guidance is credible. The initial market reaction suggests that markets are doubtful (modest further yield curve flattening; Fed dots not priced in; though the inflation data caused the bigger fixed income reaction on the day) and I have some sympathy for that reaction. As we wrote in the WEB this week, central banks (including the Fed) have systematically overestimated inflation pressures in recent years and I think there are downside risks to the Fed’s end-2018 inflation forecasts, though I do expect core inflation to gradually pick up over time.
If my assessment is correct it could be difficult for them to deliver four hikes by then while also running down the balance sheet unless there is a meaningful loosening of fiscal policy through 2018 or the Phillips Curve strongly reasserts itself. The irony therefore is that although Fed officials have mostly not factored large tax cuts into their growth and inflation forecasts, they may now be reliant on their passage to deliver the rate increases they are currently projecting.”
Standard Life Investments
Federal Reserve System Meeting Recap – June 14, 2017
- Despite softer core inflation data for the third consecutive month the Fed moved forward with the widely expected policy rate increase. The Fed Funds target range has now been lifted to 1.00% – 1.25% as the committee still expects inflation to reach the stated 2% target and that current weakness in inflation can be attributed to “transitory” factors.
- Attention was clearly focused on the Summary of Economic Projections and the committee member’s “dots” as market participants try to determine if the weaker inflation data as of late is enough to alter the Fed’s forecast for policy rates. The committee’s projection for growth was mostly unchanged except the outlook for 2017 was raised by a tenth of a percent. However the inflation forecast for 2017 was lowered from 1.9% to 1.6%.
- Another topic of notable discussion was around balance sheet reduction and today’s announcement further indicates the Fed’s willingness to begin reducing the $4 trillion balance sheet. The Fed has specifically laid out the mechanism to begin reducing the balance sheet this year. The mechanism to reduce the Feds holdings by reducing the reinvestment of principal payments in Treasury holdings by $6 billion per month and increasing by $6 billion every quarter until it reaches $30 billion per month. Reinvestment of principle payments on agency debt and mortgage-backed securities will be reduced by $4 billion per month, increasing by $4 billion per quarter up to $20 billion per month.
- While the announcement of balance sheet reduction this year was somewhat expected, the pace of reduction is somewhat quicker than we expected. The committee’s stance on inflation appears to be unchanged in light of recent soft inflation data. Most notably the “dots” remained unchanged and the Fed seems committed to normalizing policy.
- Overall, the latest announcement tilts toward the hawkish side and we are surprised market reaction is not reflecting this with a larger magnitude of price change. Currently, 10 year Treasury yields are up 3 basis points since the announcement and equity markets have sold off slightly with the S&P 500 index down almost 0.30%.