June 15, 2017

The Fed increased the short-term rate from 0.75-1% to 1-1.25%, a 25bps move. This was largely expected by the market. The Fed also maintained their forecast for one further rate hike in 2017, as reflected by the Fed dots…

Source: US Federal Reserve

What’s worth focussing on is the Fed’s statement on inflation expectations and their plan to reduce their holdings of long dated government bonds.

The Fed reduced its pce inflation expectations to 1.7%, from 1.9%, in 2017. They also note in the minutes, that ‘inflation on a 12-month basis is expected to remain somewhat below 2 percent in the near term’.

The Fed’s rate expectations remained unchanged for ’17 and ’18, at 1.4% and 2.1% respectively. They have, though, reduced the target for 2019 to 2.9%, down from 3%. Not a large move, but indicative of the generally slowing macro data we have started to see.

It’s worth re-highlighting that they still see only 1.9% GDP growth for 2019.

In terms of the Fed’s debt holdings, their statement indicated that ‘The Committee currently expects to begin implementing a balance sheet normalisation program this year, provided that the economy evolves broadly as anticipated. This program…would gradually reduce the Federal Reserve’s securities holdings by decreasing investment of principal repayments from those securities..’

The market was again expecting an announcement around the sale of these longer dated holdings, which would steepen the yield curve. The market move following the announcement is worth noting, however, with the long end of the curve tightening.

Source: Stockcharts

Long dated paper strengthened and yields declined.  This may be due to ‘China buying’, or simply that the Fed was a little ambiguous as to when the plan would start.  Yellen indicated it would be when rate normalisation is ‘well under way’ and the Fed’s view of the market at the time.

With the Citi US Economic Surprise index having collapsed fairly dramatically in the last few months, the market is interpreting that it will be less likely for the Fed to start the plan this year.

Source: Zerohedge

Inflation expectations have come off and the Fed is now pushing rate rises in a weakening environment. Wage pressures are there but, even with unemployment at lows of 4.3%, it hasn’t come through in the inflation data.

Source: Federal Reserve Bank of St. Louis

Several commentators have highlighted concern that the Fed may be making a policy error, pushing rates higher, just as economic data is weakening. I think that misses the point. In my view the last two decades of Fed policy have been in error, starting with Greenspan fuelling the markets in the late 90s and then the housing bubble.

This has been the longest stretch of sub 1.5% rates ever. That, with the weak economic data we continue to see, just highlights that, while the Fed and other central banks ‘saved the day’ in ’08/’09, their policy mix has led to a weak recovery. The weak (banks and leveraged investors) were saved and the prudent investors/savers penalised. The 1930’s recession and market sell off was far deeper, but the recovery was that much stronger. It’s worth noting that average GDP data for both periods is similar, at around 1.3%.

Markets move in cycles and the Fed’s policy may drive growth/employment higher on the short to medium term, but eventually there will be a price to be paid for the largesse. Mal-investment seems to be a human condition, the extent of which is only witnessed when the tide is out.

With this in mind, the move higher in long dated treasury yields in late ‘16 was likely overdone.

Source: Stockcharts

While long term US government bond yields may be volatile, they may go lower, or retrace, over the next yr or so, certainly as and when the current cycle ends.