At this point, the Federal Reserve’s December increase of the Federal Funds Rate has left limited traces of any action whatsoever. Yields are in fact lower. 2016 started off on a less than auspicious note, and the world seems overwhelmed by concerns about migration, geopolitics, climate change, slumping commodity prices, currency devaluations, and equity market slumps. Given this, it’s not much wonder that fixed income, as low yielding as it is, has again witnessed a flight to quality. As a result, we see a lower yield curve regardless of the fact that the Fed increased the Federal Funds Rate.
Importantly, the Fed’s effort to lift rates reflects good news: an economy that they believe no longer needs monetary policy set on extreme emergency settings. Yet this transition to better economic conditions triggers an adjustment process that is anything but straightforward. Over the past several years, extremely low yields in and of themselves have contributed to a search for yield by investors. This process supported financial risk taking, which led to higher valuations for equities and credit as these assets were bid up. As a result, the Fed now has to perform an intricate balancing act: moving rates towards levels more in keeping with a sense of normalcy, while at the same time minimizing disruptions in financial markets.
If we look to the Fed for expectations of what they might do and what the path of yields might be, we wonder: are they data dependent, market dependent, or forecast dependent? What will motivate the Fed’s decisions?
Data dependence is about seeing “the whites of the eyes” of inflation, or growth, or some other economic measurement. The current wisdom is that the U.S. economy, as somewhat of a global outlier, is doing at least as well as, and in most cases better, than the rest of the world. The recent strong employment report demonstrated that. As investors, we want to know whether this continues. We believe it’s likely the economy does plod along at something like 2% growth. But unless there is some upward shock to inflation, it’s unclear that data alone is going to warrant the Fed further removing monetary policy accommodation.
The second question is about whether the forward path of interest rates is market dependent, and the Fed’s actions will be guided by market movements. That has to do with macroeconomic forces that are more global than just domestic considerations. Certainly the decline in Chinese markets, triggered by devaluation of their currency, has unnerved markets. Importantly, we wonder the extent to which declines in Chinese currency and equity markets could have a direct impact on the U.S. Our answer so far is “not yet”, but we are watching this carefully.
The last question is about forecasts, and simply put, the Fed certainly realizes that their forecasts have been terrible. It seems that they do not have better crystal balls than the Phillips Curve and other “demand side” models. These would indicate that the fall in unemployment should lead to price pressures, yet we see few such signs of potential inflation. Instead, the world is a place with a surplus of supply and that makes all the difference.
At this point, market actions have largely been about whether a solid path of job creation in the U.S. is more important than market declines in China and other indicators of a fragile world out there. So far, it appears the global markets story is being judged by the U.S. markets as more significant than domestic economic data.
The fixed income markets also offer contrasting viewpoints. Credit spreads have been widening for more than half a year, while yields have still moved lower. This indicates that interest rate markets and credit markets are out of synch. Rates are supposed to move higher with an improving economy, which typically indicates improved corporate profitability and upward price pressures. But the credit cycle is saying something different: it’s saying that profitability is not improving and arguing price pressures, if any, are downward. This is difficult to reconcile but reflects the complicated/complex adjustment process of trying to exit a zero interest rate environment.
At the same time, we also have central banks around the world going in different directions: the U.S. and potentially the U.K. are tightening, while the rest of the world still looks to ease. With a backdrop of uncertainty such as this, we would anticipate continued volatility as the market finds its stride.
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