The Fed’s Conundrum and the Future of Interest RatesBy Bob Andres | Aug 05, 2015
- Both inflation and early third quarter economic data are lining up against the Fed – suspect this means a flyby in September.
- Reports of the demise of the bond market are greatly exaggerated. I would not be surprised to see the 10-year under 2.0% and the long bond under 2.50% as a result of weakening growth, rising deflationary pressures, treasury demand exceeding supply, Sovereign debt spreads favorable to treasuries creating foreign demand, flight to quality as equities get more overbought and geo-political risks continue to rise.
- The curve will continue to flatten although possibly unevenly. Since April 16th the 2-year has risen from .48% to .73% while the 30-year has declined from 3.23% in early June to a current level of 2.87%.
- Expect that low rates will be with us for an extended period.
- Municipals remain very cheap when compared to all taxable paper.
- The consensus has had us on flight to much higher rates – the consensus is never correct.
- Investors should listen to the bond market as a forecaster, not the noise generated by self interest groups.
- Contrary to current consensus thinking, we are likely to see a period of relative stability in the domestic bond markets for the foreseeable future.
Janet Yellen and the committee are anxious to initiate the process of normalizing interest rates. They understand the importance of having some traditional tools back in the toolbox to fight the unexpected economic event should it occur. However, the Federal Reserve (Fed) continues to recognize that raising rates too early represents both an organizational risk and a personal risk to Janet Yellen’s legacy. Unfortunately, the Fed has been dealt a difficult hand: The second longest and weakest economic recovery in the post war period and the reality that they will have to maneuverer the Fed funds rate higher utilizing non-traditional and untested – in the real world – methods. The two principal strategies they are expected to employ are interest on excess reserves and reverse repos. Neither of these strategies represent “a smart bomb” – they both have their shortcomings.
For a full understanding of the pre and post crisis Fed strategies go to AndresReview.com for a terrific explanation of the topic by the Hutchins Center.
The entire discussion of when the Fed will initiate a normalization process needs to be put in perspective. The first Fed move, whenever it takes place, is not necessarily a portent of additional moves. All future considerations will be data dependent. Clearly, a trend to broadly higher rates is dependent on the U.S. economy growing at a much faster rate then the 2.0% average we have seen over the last 4-years. In addition, growth will have to be more consistent and in my judgment average closer to 3.0% for rates to trend significantly higher. The Fed’s current long-term growth forecast is 2.0% to 2.3%. Their short-term forecast for 2016 and 2017 are 2.4% to 2.7% and 2.1% to 2.5% respectively. I would remind all that the Fed’s forecasting record is abysmal. The Fed defines the term “aggressive optimism.” They are currently forecasting growth this year of 1.8% to 2.0% down from their March projection of 2.3% to 2.7%. I will also remind everyone that in the recent past the Fed had more favorable economic and inflationary periods than they have today to raise rates.
Inflation and the economy are the fundamental drivers of interest rate directional moves. The Fed targets a 2.0% inflation rate as measured by the change in the price index for the personal consumption expenditures, or PCE. The Fed’s rationale is that allowing a higher rate of inflation over time would reduce the public’s ability to make accurate longer-term economic and financial decisions while a lower rate of inflation would generate deflationary concerns. Unfortunately, this index has been under the 2.0% target for over three years and the most recent data for June shows the index dropping further to an annual rate of 1.3%.
To the economic bulls calling for “liftoff,” I ask the question, what will be the engine of organic growth? A strong dollar, a flattening yield curve, an enormous debt burden, low savings rates, an aging population, rising geo-political events, increasing regulations, slow global growth, corporations holding enormous amounts of cash, immigration reform, and lower commodities prices are clear headwinds to an economic liftoff. Declining oil prices, while transitory, can help the consumer but are a two-edge sword economically.
Remember all bonds are not created equal!