The Fed Bets on Growth

Central bank watch

The Fed Bets on Growth

Chair Janet Yellen's last FOMC decision was talked into financial markets months, if not years in advance. And the Fed increased its economic forecasts somewhat. But not all market participants - or FOMC members, see the future the same way.

To nearly nobody’s surprise, the Federal Open Market Committee (FOMC) raised its benchmark Fed Funds target rate to 1.50%, a 25 basis point (bps) rise. This is the 5th hike since the Federal Reserve (Fed) began lifting its reference rate at the end of 2015. The Fed left its projection to lift rates three more times next year unchanged, and raised its forecasts: Gross Domestic Product growth to 2.5%, from 2.1%, for 2018; to 2.1%, from 2%, for 2019, and 2% from 1.8% for 2020. 

 

This is what our fixed income affiliates say:

John Bellows, Portfolio Manager and Research Analyst, Western Asset: "The Fed raised rates without making any substantive changes to its outlook for future rate hikes. This is all the more notable given the apparent strength in US growth and the recent progress on tax reform, which together contributed to an upgraded forecast for 2018 and 2019 growth. The Fed’s patience on rates, even as the growth outlook has improved, likely reflects the persistent uncertainty about inflation. Indeed, two members of the committee thought the uncertainty on inflation was sufficient to warrant keeping the fed funds rates unchanged. In our view, the inflation outlook is likely to remain a sticking point for the Fed, constraining the pace of hikes now and the eventual level of terminal fed funds later.

Almost simultaneously, Congressional leaders announced that a deal has been reached on tax reform. The bill features significant net tax cuts, which as Chair Yellen indicated, were reflected in the Fed’s outlook through a modest upward boost to growth in the near term.

The Fed’s patience regarding the rates outlook is notable and understandable given the uncertainties surrounding inflation. While tax reform is likely a near-term positive for growth, it is not without its own uncertainties, which the Fed and the market will track closely next year. We continue to think the inflation outlook will be constraining, and the Fed will be appropriately cautious in response."

 

Jack McIntyre, Portfolio Manager, Brandywine Global:  "We believe there was an underlying perception that the Fed could have included four rate hikes in its 2018 rate projections. Since there are only three rate hikes projected for 2018, the Fed’s December 2017 rate increase is more of a dovish rather than hawkish rate hike. To us, these projections are just noise—they are a forecasting tool, when in reality, the Fed will continue to monitor market and economic conditions. Ultimately, Fed policymaking will remain data dependent. For example, core consumer price inflation (CPI) registered lower at the December meeting, and while we have not seen a recent reading on the Fed’s preferred inflation metric—core personal consumption expenditures (PCE)— we do know this measure has persistently remained below the Fed’s 2% target. The March 2018 FOMC meeting will be an important one given the Fed’s impending leadership transition. We do not think Powell will want to “rock the Fed boat” unless something changes dramatically. Therefore, the Fed should be on cruise control for much of 2018 as it just laid out the roadmap for next year at the December meeting. Interestingly, there were two dissenters who were in favor of not hiking rates at the December meeting—which has been a very rare development—so perhaps the Fed should consider taking the March hike off the table for now."

 

Markets Say: "Not So Fast..."

Financial markets have expressed a far less optimistic view than the Fed for months. Yields on 30-year US Treasuries have fallen nearly 30 bps since the beginning of the year as yields on the shorter end of the curve have risen markedly (1-year Treasury yields are up 86 bps). This flattening of the yield curve is seen by some as a harbinger of stalling growth.

Western Asset Chief Investment Officer Ken Leech compares the US yield curve to Cassandra, a Greek mythology figure whose predictions were always right, yet never believed - a mistake that investors, such as Western Asset, want to avoid. In Ken Leech's words: “We take the warning sign of the yield curve at face value.” 

Other investors agree: as seen on the chart below, the Fed's interest rate projections (before the latest meeting) widely differed from the market's.

 

The Fed vs the markets: different interest rate projections

 

 

 

 

 

But The Minority grew, and Markets Still Say: "Not So Fast..."

Surprisingly, the two dissenting members of the FOMC, Charles Evans and Neel Kashkari voted against the hike, saying the economy needed more time to gather steam.

Financial markets, also appear to have had a different view so far. Yields on 30-year US Treasuries have fallen nearly 30 bps since the beginning of the year as yields on the shorter end of the curve have risen markedly (1-year Treasury yields are up 86 bps). This flattening of the yield curve is seen by some as a harbinger of stalling growth.1

Western Asset Chief Investment Officer Ken Leech compares the US yield curve to Cassandra, a figure from Greek mythology whose predictions were always right, yet never believed - a mistake that investors, such as Western Asset, want to avoid. In Ken Leech's words: “We take the warning sign of the yield curve at face value.” 

 

 

 

 

 

 

But The Minority grew, and Markets Still Say: "Not So Fast..."

Surprisingly, the two dissenting members of the FOMC, Charles Evans and Neel Kashkari voted against the hike, saying the economy needed more time to gather steam.

Financial markets, also appear to have had a different view so far. Yields on 30-year US Treasuries have fallen nearly 30 bps since the beginning of the year as yields on the shorter end of the curve have risen markedly (1-year Treasury yields are up 86 bps). This flattening of the yield curve is seen by some as a harbinger of stalling growth.1

Western Asset Chief Investment Officer Ken Leech compares the US yield curve to Cassandra, a figure from Greek mythology whose predictions were always right, yet never believed - a mistake that investors, such as Western Asset, want to avoid. In Ken Leech's words: “We take the warning sign of the yield curve at face value.” 

 

 

 

 

 

 

But The Minority grew, and Markets Still Say: "Not So Fast..."

Surprisingly, the two dissenting members of the FOMC, Charles Evans and Neel Kashkari voted against the hike, saying the economy needed more time to gather steam.

Financial markets, also appear to have had a different view so far. Yields on 30-year US Treasuries have fallen nearly 30 bps since the beginning of the year as yields on the shorter end of the curve have risen markedly (1-year Treasury yields are up 86 bps). This flattening of the yield curve is seen by some as a harbinger of stalling growth.1

Western Asset Chief Investment Officer Ken Leech compares the US yield curve to Cassandra, a figure from Greek mythology whose predictions were always right, yet never believed - a mistake that investors, such as Western Asset, want to avoid. In Ken Leech's words: “We take the warning sign of the yield curve at face value.” 

 

Source: Bloomberg Barclays Capital 6 Dec. 2017. FOMC is the median estimate from members of the rate-setting Federal Open Markets Committee. Please see disclaimers for definitions.

 

This divergence is mainly due to the lack of inflation and inflationary pressures: while US unemployment has dropped to 4.1%, the lowest since 2001, wage growth is not accelerating and inflation remains relatively subdued. The Fed mostly believes this is a temporary issue, while some investors say this is because of technology developments, which push the price of certain services lower, as well as due to the globalisation of resources. Others blame aging Western societies that save more than spend, or the decreasing power of unions. 

Whichever the cause, the fact is that inflation has been stubbornly low, anchoring long-maturity Treasuries and ultimately flattening the yield curve, despite the Fed's efforts to ignite future growth. This is why some asset managers, such as Brandywine Global, see greater opportunity in Emerging Markets, given their above-average growth and improving fundamentals. Click here to read Brandywine Global's "Around the Curve" blog: Emerging Markets: Dangerous? Or Just Like the Rest?

Only time will tell whether a new balance will be struck between the believers in growth and the more skeptical “show-me” participants in bond markets. During this tension, and as major central banks withdraw their decade-long monetary stimuli, active managers with an unconstrained approach may help investors find the choice that suits them best.

 

 

1 Source: Bloomberg, Dec 13 2017, 2:15 PM ET.

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