· Fed Preparing for ‘mid-’15 Since September ’12 FOMC
· ‘Lift off’ Date Commands Attention – Pace Thereafter
· Equilibrium Longer Run Fed Funds
· Dollar Strength No Reason to Delay ‘Normalizing’
· Absent ’04-’06 Policy-Path Redux-Where Guidance
· Treasury Curve and ‘Normalization’
Fed Preparing for ‘mid-’15 since September ’12 FOMC
Do not take too lightly the fact that the Fed has been preparing for a ‘mid-2015’ policy move since the September 2012 FOMC meeting. Two and a half years ago, the Fed made a final adjustment to the ‘date-based’ guidance saying; “In particular, the Committee also decided today to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that exceptionally low levels for the federal funds rate are likely to be warranted at least through mid-2015.”
Although at the December 2012 FOMC meeting, ‘threshold guidance’ took the place of the date-based guidance, the Fed made it clear that; “The Committee views these thresholds as consistent with its earlier date-based guidance.”
As the Fed prepares to remove the language; ”Based on its current assessment, the Committee judges that it can be patient in beginning to normalize the stance of monetary policy.”, we should be mindful that removal of the ‘patience’ language means the FOMC will begin considering a rate hike on a meeting-by-meeting basis. Still, what a feather in their cap should the Fed be seen as being able to offer policy transparency 2.5 years into the future during trying economic times.
‘Lift off’ Date Commands Attention – Pace Thereafter
The Fed warns that too much attention has been directed toward the lift-off date for fed funds, further advising that the pace and extent of policy firming matter more and will have a greater impact on the economy and financial markets than will the timing of the first policy rate move. Despite these urgings, economic agents have had a laser focus on the ‘lift-off’ date.
This has not worked entirely against the Fed’s interest as market priced policy rate projections have been lower than the Fed’s own forecast, providing additional support even as the Fed readies to normalize policy. The more modest and less steeply sloped market priced policy rate projection have helped to hold down shorter dated treasury rates, and possibly longer dated Treasuries, making financial conditions slightly more accommodative.
Following the fed funds ‘lift off’ or possibly as soon as that timing is more universally understood, economic agents may direct their focus more acutely upon the balance of the normalization process. One aspect that may find sharp adjustment is the difference between the Fed and market priced projections for policy rates. Recent research by Hamilton, Harris, Hatzius and West suggest economic conditions could benefit from a delayed start to policy firming and a more aggressive ‘catch-up’ later. Knowing that the Fed has every intention to secure its mandate, any start date for lift off implies that the Fed will have already delayed and is ready to proceed cautiously.
Equilibrium Longer Run Fed Funds
The Fed has been lowering its expectations for the equilibrium longer run level of fed funds for years. The difference between what the Fed is projecting and the market was pricing moved to about 160 basis points in January. While that chasm has been slightly closed, there is still roughly 130 bps differentiating the Fed’s path projections from futures prices.
To understand why there is such a large gap between the Fed’s projection and the markets pricing we might recognize that along with the steady reduction in longer run policy rate forecast the Fed has also steadily reduced its forecast for real GDP growth since 2012. Economic agents have come to rely on continued reductions in these variables and have simply extended the trend line for subsequent terminal policy rate and longer run equilibrium growth rate reductions beyond the Fed current forecasts.
Over the last two quarterly SEP reports however the average longer run policy rate projection has not fallen, but remained 3.78-3.79% and the longer run real GDP forecast has stayed 2.15% in the last two SEP reports. The trend toward lower longer run policy rate and real GDP growth forecasts from the Fed is likely over. Still, a SEP report showing a higher level in both longer run equilibrium fed funds and real GDP growth may be required before economic agents decide to abandon what to this point has been a strong trend.
When at the March FOMC meeting, the Fed fails to further reduce the longer run growth and equilibrium fed funds forecast or even raises these forecasts, we should expect to see the spread between the market priced implied fed funds forecast and the Fed’s own forecast start to converge with the market priced yields moving higher toward the Fed’s projections.
Dollar Strength No Reason to Delay ‘Normalizing’
Concerns have been expressed that the strength of the dollar is reason for the Fed to postpone ‘normalizing’ its overly accommodative monetary policy stance. Arguments have been that the dollar is doing the Fed’s work and choking off growth in manufacturing and export industries and therefore the Fed need not raise rates lest they jeopardize fragile growth prospects.
In reviewing the dollar index trade patterns following subsequent tightening cycles dating to the mid-‘80’s, we note that following each of those lift off dates, the dollar index fell over the next months, whether it was peaking on approach of the Fed’s action or already sliding lower. On average, the dollar index fell 14% over the next 9 months following the last four Fed policy firming initiations. Using this as a rough guide, we might look for a pull-back in the dollar index from 100 to 86 by Q1 2016.
The rational here is obviously that the dollar has already strengthened both on the back of better U.S. domestic economic prospects and in anticipation of Fed raising policy rates. The latter having been priced may prompt long dollar position holders to take profits upon initiation of Fed accommodation removal. As such, the Fed need not fear prompting dollar strength on ‘lift-off’ and instead should proceed in proving the market correct in their assessment of monetary policy intent.
Absent ’04-’06 Policy-Path Redux-Where Guidance
Although I harped back in ’05-’06 (‘The Dark Side of Transparency’ and ‘A Pause in August (’06) Means A Pause in September’) on the dangers of too visible a policy path during accommodation removal, I was unable to find the Fed’s ear. Thankfully today there seems to be rather strong opinion at the Fed that too much guidance about the policy rate during ‘normalization’ would not be a good thing. So we should not expect the Fed to offer overly abundant guidance about its specific policy rate plans over the coming years as it moves toward lower levels of accommodation. Instead, the Fed will openly debate and communicate their understandings of current and intermediate term economic and inflationary conditions so that economic agents might interpret a likely policy prescription.
However, to the consternation of many, market participants have become accustomed to some measure of guidance for so long that a ‘cold turkey’ withdrawal may result in unwanted extreme risk appetite reduction. The traverse beyond middle ground between accommodation and accommodation removal will bring some relief from the uncertainty associated with the ‘when’ of monetary policy firming and will likely prompt, at least initially, some renewed risk assumption.
After the policy rate lift off, the Fed will be prepared to provide some additional guidance in the form of a ‘policy-path’ in the reduction in levels of reinvestment of principal and interest on maturing securities in their portfolio. This will act similarly to the ‘policy-path’ tapering of securities purchases and could, counter intuitively, lend some support to financial markets (see ‘Unconventional Policy Guidance; Then and Now’ in FOMC Report January 28-29, 2014).
Treasury Curve and ‘Normalization’
I have been a steady follower of the Treasury 5-30 yield curve spread and have since early-2014 projected a stronger flattening than forwards had priced. Right now the spread trades to 108 bps and not far from the recent low of 102.
There have been several instances since January where this yield spread has moved temporarily wider, though in each instance the advance stalled at lower levels. The latest of these advances came from near current levels and reached only to 116. The consecutively lower stall points suggest that momentum cannot build. Therefore, a move lower is likely soon enough.
The below chart examines the last three instances where the Fed began to move policy rates higher and the response seen in the 5-30 yield spread. Based on the average of these Treasury yield curve moves following prior FOMC lift off’s , one could make an argument for the Treasury 5-30 yield curve spread moving 116 basis points lower to -8 by June of 2016 from roughly 108 now.
Finally, something to keep in mind for when you think later on that the Fed is finished firming policy; note that in two times out of three since the mid ‘90’s the low yield spread reached on the 5-30 Treasury spread came within a month of the last restrictive policy rate move. In 2006, the low point on the 5-30 spread came about four months earlier than the last rate move, begging the question; did the Fed stay on the breaks too long? In any case, the recent average move in the Treasury curve following the start of accommodation removal is a rather simple guide. And while scarcity of non-Fed-held long dated Treasuries, U.S. to foreign yield differentials and Fed’s balance sheet implications for policy rate are very complex issues worth factoring, often times a simple guide is a welcome distraction.