The U.S. Federal Reserve (Fed) left its target rate unchanged, as was widely expected. But the bigger news is the beginning, in October, of the Great Balance Sheet Unwind, as the Fed moves toward policy normalization. Read on for insights from our Portfolio Managers:
"In October, the Committee will initiate the balance sheet normalization program" - Federal Reserve
The Fed gave its first clear plan for the drawdown: reductions of $10 billion per month, starting in October, and gradually rising over the next year to $50 billion per month. The asset mix wasn't specified; a target size of the balance sheet wasn't discussed.
Chair Yellen was clear that the balance sheet plan wasn't to be viewed as an additional tool of monetary policy; it would proceed independent of rate decisions, and only deviate from plan if absolutely needed.
But not all observers agreed. Said Brandywine Global's Jack McIntyre," We believe the Fed’s balance sheet will still be used as a tool – in this instance, to tighten monetary conditions."
Beyond the headline-grabbing news about the official start and moderate pace of balance sheet reductions in October – is the market's growing acceptance of the likelihood of a third hike in the fed funds target rate by the end of 2017.
Since the last rate hike by the Fed’s Open Market Committee (FOMC) in June, economic data have been decidedly mixed – leading many observers with the impression that the Fed was done with hikes for the year. But as September unfolded and the Fed’s informal economic survey – the Beige Book – was released on September 7, it became clear that the Fed’s belief in the strength of the economy was increasing.
The shift showed up clearly in financial markets; the implied probability of a rate hike by the December FOMC meeting rose rapidly, crossing 50% on the upside by the beginning of the following week.
And as confirmation, the Fed's own forecast for the rest of 2017 and for 2018 – the so-called "dot plot", includes one more rate hike this year.
Even Steven: Fed funds futures reflect growing belief in a rate hike in 2017
Source: Bloomberg, September 18 2017. Past performance is no guarantee of future results. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.
In short, the balance of the year could be a cliff-hanger for financial markets, as well as for the larger global economy.
The market for U.S. Treasuries has clearly been paying attention: the yield curve has risen at the short end as the FOMC hiked rates during the year; and flattened at the long end in anticipation of the presumed impact of higher rates on growth.
The Curve Takes Note:
Changes in U.S. Treasury yields, Dec 31 2016 - Sept 15 2017
Source: Bloomberg, September 18 2017 Please note: top graph shows yields to maturities in percentage points; bottom graph shows change in yields in basis points (bps), hundredths of percentage points. Past performance is no guarantee of future results. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.
Investment Manager reactions:
Western Asset observes that a December rate hike is not yet priced into the broader market, but would be consistent with the Fed's overall objectives, along with the current environment of improving economic health worldwide. A second factor, though less important: the effect of the depreciation of the U.S. dollar has been accommodative, allowing for more room for a rate hike's impact before unwanted effects of inflation take hold.
“This Fed does not want to run the risk of surprising markets. The Fed has adopted a third, implicit mandate of financial market stability: ‘Do no harm.’”
- Jack McIntyre, Global Fixed Income Portfolio Manager
"Central banks are aiming for a steady unwind, not a fire sale, and communciation will be a key ingredient."
- J. Patrick (Pat) Bradley, Senior Vice President, Investment Research
“While it is true that some FOMC members remain cautious, we think continued growth and accommodative financial conditions are likely to tip the considerations toward another hike.We think the Fed is more likely than not to hike in December.”
- John Bellows, Ph.D., Portfolio Manager and Research Analyst
Finding value in today's environment
Given the current generally low interest rate environment, both Brandywine Global and Western Asset are finding strong value in Emerging Market local-currency bonds. Real interest rates in these markets are high and in many cases inflation is declining, positioning some of these markets to benefit from improvements in global growth already under way.
For more reading on Legg Mason's investment managers and their views on the current environment:
- Brandywine Global on the beginning of the Fed's "Quantitative tightening"
- Western Asset's Ken Leech: The U.S. and global economies are healing (quarterly update)
- Four Lessons from the Taper Tantrum John Bellows, Ph.D., Western Asset