US rate normalization - here we go?

Central Bank Watch

US rate normalization - here we go?

The US Federal Reserve (Fed) lifted interest rates, as expected, and committed to 2 more hikes later this year. The move signals the central bank's resolve to...

bring rates back to a level more in tune with the present heartbeat of the economy, after being kept at or near record lows since the 2007-08 crises - a process known as normalization.

Despite the quarter-point hike to 1%, the Fed's reassurance of its accomodative stance and chair Yellen's comments about the US economy being expected to keep a moderate pace, ignited a rally in both bond and equity markets, as well as in commodities and Emerging Market currencies. The US dollar softened. Financial assets have traditionally benefited from this goldilocks backdrop: strong enough to lift corporate profits and keep default rates in check, but slow enough to keep interest rates low, reducing corporate financing costs. 

 

WHAT DID OUR PORTFOLIO MANAGERS SAY?

Western Asset: John Bellows, Portfolio Manager, Research Analyst

"An interesting question is why did the Fed move interest rates if there was no change to its outlook?  Two considerations are relevant.  First, in the Fed’s view, the US economy is close to full capacity and even “as expected” data on growth and inflation will justify gradually higher rates. The recent US economic data has been, indeed, broadly as expected, therefore clearing this low bar.  Second, the Fed is likely responding to the sharp easing in financial conditions that has occurred over the past few months. It’s important to remember that financial conditions can be volatile and fragile and, understandably, the Fed refrained from incorporating an additional easing of financial conditions into their outlook going forward. Nonetheless, financial conditions will likely continue to be an important part of the Fed’s actions this year. Bond yields have moved lower in response to the Fed’s actions. By communicating that little has changed in the broader outlook, the Fed likely disappointed investors looking for signals of a more significant shift in the Fed’s thinking."   

 

Brandywine Global: Jack P. McIntyre, Portfolio Manager

"The Fed already tightened, starting weeks ago when one Federal Open Market Committee (FOMC) member after another made hawkish statements in an effort to prep markets for an actual rate hike at the March FOMC meeting. So, I believe it was no surprise that the Fed tightened by 25 basis points (bps). However, what was surprising was that the FOMC text and rate projections didn’t match the hawkish tone that emanated from many Fed officials prior to the March 15 meeting. There was an increasing view that the Fed could tighten four times this year, but this notion was not confirmed in their projections, which continued to reflect only three moves in 2017. Chair Yellen did not discuss the Fed’s balance sheet which has dovish undertones,  or the FOMC text in her press conference; I think the markets will like this element of gradualism. The bottom line is the Fed is not behind the curve — maybe it is versus sentiment-based economic releases — but it’s not based on actual, real economic data which shows that 1Q 2017 gross domestic product growth won’t be much different from 4Q 2017."

 

 Royce & Associates: Steve Lipper, Senior Investment Strategist

"Investors looking to reduce interest rate risk because of concerns about rising rates might want to consider adding small-cap stocks, which historically have lower sensitivity to rate changes than large caps."


The Fed's moderate tone on Wednesday vindicated those investors who have a more cautious view over the US economy and who question whether the country is ready for a fast-paced rate normalization process.

 

Where's the real growth?

Data has been strong: unemployment has fallen to 4.7%; inflation, at 1.7%, is close to the Fed's 2% target; the once ailing manufacturing sector is recovering, pushing economic growth to 1.9%. Wages are picking up.

Also, the international headwinds that contributed to the Fed's reluctance to raise rates more than once last year seem to be abating: European Central Bank president Mario Draghi recently proclaimed victory against deflation, while Japan's economy has strengthened three quarters in a row.

The Fed has been trying to bring rates back to a more normal level since 2013, when former chair Ben Bernanke first announced his intention to start withdrawing the central bank's monetary support - an episode known as "taper tantrum" that caused a market plunge. 

Four years later, Wednesday's hike signals the Fed is now more confident about rate normalization. According to economic theory, long-term rates should be somewhere near the sum of inflation and growth, or roughly 3.6%, in this case. This is far from the present level, as 10-year Treasury bonds currently yield about 2.5%.

Why aren't long-term rates or real rates (the difference between nominal rates and inflation expectations) picking up? 

 

Mind the gap: nominal vs real

Source: Bloomberg as of 13 March 2017. UST is US Treasury; yr is year; breakeven rate is the difference between nominal and inflation-adjusted rates. RHS is right hand side.

 

Some investors believe that while global and US recoveries are ongoing, they still face structural issues such as lower productivity, aging populations and long-term changes in the labor market that partially contain wage growth. Oil prices, a key driver of inflation, are also kept in check by increased US shale production and the more popular clean energy alternatives. 

According to Western Asset's CIO Ken Leech, the cyclical upswing in the US has to be viewed against a fledgling global recovery and a secular growth environment with ongoing challenges.

Political uncertainty is especially on the rise: in the US, investors are keen to hear more specific details about the new Administration's planned tax reform, infrastructure changes and trade policy - which could affect global growth.

And Europe faces three national elections that could challenge the entire European Union project. Click on the following links for: 

As usual, uncertainty is the only certainty ahead – and markets are pricing it, something that usually is accompanied with higher levels of volatility. In such scenario, active and flexible money management may bring investors a wider range of opportunities, as well as a variety of tools aimed at increasing protection as well as enhancing returns. 

 

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