In each of the prior three rate hikes since the end of 2015, we saw some suspense surrounding potential action from the Fed, whether because of nervousness as to what a post-financial crisis tightening cycle would look like or skepticism that the central bank would get out in front of the bond market.
Even in March, when the Fed raised rates to align with prospects for modestly higher growth, there was some uncertainty and market turbulence in the run-up to the meeting as investors gauged the influence of an uneven economic performance.
At this week’s June meeting, however, any drama was definitely in intermission. The market had set the potential for a rate increase at 80 per cent, 90 per cent or higher for a few months, and reached 96 per cent by this past Monday, as steady economic growth, low unemployment and other indicators seemed to support a continuation of the gradual tightening campaign. As expected, the FOMC raised rates by 25 basis points to 1 to 1.25 per cent and reiterated its view that gradual deleveraging of the Fed balance sheet would begin when normalisation of Fed funds was well underway.
At the same time, it released a game plan for eventual balance sheet reduction, which would involve trimming reinvestment by up to $6bn in Treasuries and $4bn in mortgage securities, with the limits gradually increasing to a maximum of $30bn and $20bn, respectively.
If the rates move was anti-climactic, it does usher in a period that could provide more plot twists for investors. Further rate increases remain uncertain for 2017. Current market expectations point towards one or two more increases before the Fed is done in this hiking cycle. Signals from other markets such as a collapse in realised and implied equity volatility, dollar weakening versus most currencies and the flattening of the yield curve are also reflecting those expectations.
Retreat from the reflation trade
Taking a step back, the reflation trade has been at the centre of market activity since November, when the election created anticipation of growth-friendly government policy, including tax cuts, reduced regulation and infrastructure spending—this after an extended period when the US government had failed to contribute much of anything to the current economic cycle.
The follow-up has been pretty disappointing, however, as myriad distractions and legislative torpor have combined with unspectacular economic data to reduce optimism on US growth, from a “dreamy” 3 per cent to more mundane but near-goldilocks 2 per cent rate.
That’s nothing to sniff at. Unemployment is now just 4.3 per cent and payrolls continue to expand at a healthy clip; financial conditions remain benign, on par with a year ago. Still, some sectors like telecommunications and autos are showing overcapacity.
Just as important, inflation trends have been sluggish. Last week, the ECB reduced its 2018 forecast from 1.6 per cent to 1.3 per cent, while the Fed now expects US core PCE inflation to reach just 1.7 per cent this year – down from 1.9 per cent – reflecting a lack of progress on pricing goals. Interestingly, the Fed left its 2018 inflation expectation unchanged, which along with consistent growth and rate hike views for next year appears to show virtually no angst on their part concerning recent disappointments.
Reflecting the soft pricing news, commodities have largely moved sideways for the past few months while breakeven inflation reflected in Treasury Inflation-Protected Securities has shown weakness. Progress in realising inflation stalled, for example the services component of inflation (64 per cent weight in the CPI basket) that used to run at 0.3 per cent on a monthly basis, but post the big negative surprise number in March has been recovering at a lower rate of 0.2 per cent. Meanwhile, financials have underperformed the overall stock market and, as noted, the yield curve has flattened considerably.
New flexibility, more uncertainty
With inflation below targets, the Fed has more room to be patient and take it slower in the second half of the year, with perhaps just one more increase in 2017. A key variable is likely the shape of the yield curve, which has been particularly flat and may reflect some economic pessimism on the part of the bond market.
One way to “un-bend” the curve would be to slow the pace of rate increases over the next year. Another would be to trim the balance sheet modestly, as discussed by the Fed, curbing reinvestment of maturing holdings, often in the middle part of the curve. There is no set starting point, but the Fed did indicate that such action was likely to take place this year.
All of this is not to say that we are in for a major surprise here, but the plot does become less predictable, which could open up new opportunities to exploit inefficiencies in the marketplace.
Thanos Bardas is head of interest rates and sovereigns at Neuberger Berman