Tuesday, June 16, 2015

FOMC Report June 16-17, 2015; Fed Coming Late to Party



Nearly Three Years of Policy Visibility

The Fed has added to its stores of creditability by maintaining its policy rate at a long-promised artificially low level through midyear-2015.  However, it will be paying back from those supplies if it should remain sidelined much longer while employment and inflation continue to repair.  

At an FOMC meeting in September 2012, the Fed made a last adjustment to its dated-based policy guidance, saying; ‘exceptionally low levels for the federal funds rate are likely to be warranted at least through mid-2015.’  While that last date-based policy guidance lasted only until December of that year before the Fed adopted ‘threshold’-based guidance, the Fed advised at that time; ‘The Committee views these thresholds as consistent with its earlier date-based guidance.’  Any change to policy guidance since has included a reference that the change does not alter the intent of the prior guidance message.  In a way then the dated guidance of ‘at least through mid-2015’ still stands.

Since the September 2012 FOMC meeting and before, expectations for above trend growth have been followed by consistent and cumulative declines in the potential output expectations.  Back in late 2012, the Fed thought the longer run growth potential for real GDP was 2.3-2.5%.  At the March FOMC meeting earlier this year the Summary of Economic Projections (SEP) reported longer run growth prospects were believed to be only 2.0-2.3%. 

Some argue that because of this reduction in expectations for potential output, the Fed has greater leeway to firm its policy stance under slower than once assumed growth conditions.  If correct in assuming the potential growth is as low as 2.0-2.3%, Fed officials must also be prepared to accept that they were, for a time, running a more accommodative policy stance then they had earlier imagined. 

Unfortunately perhaps, the outflow of that greater than intended level of accommodation has not to date brought about consistently above trend growth levels.  And while current year over year and projected growth over the next year are considered by the Fed to be above trend relative to latest SEP, there has been no meaningful rise in inflation thus far.  It is likely therefore that either potential growth is higher than the Fed’s 2.0-2.3% longer run expectation or that there are latent but building inflationary pressures.  At this juncture however, with the fresh memory of weak Q1 growth, a greater majority would instead highlight the fact that despite higher than anticipated levels of monetary policy accommodation over the last years, neither growth nor inflation has yet achieved critical levels.      

It is difficult to remain encouraged by the additional repairs to household balance sheets and to the abundance of cash on balance with businesses.  These strong positions suggest the ability to generate invigorated spending and investment levels, thus raising growth and employment conditions.  A late arrival of the beneficial impact from improved balance sheet conditions however, may find their eventual appearance a surprising event and not without some positive adjustment to growth, employment inflation expectations.


Illiquidity Concerns

There has been considerable and likely exaggerated concern about the prospects for a spike in long rates following a Fed announced rise in the fed funds policy rate.  Many point to the mid-2013 ‘Taper Tantrum’ as reason to be concerned.  Others, more correctly recognize the reduced presence of bank positioning as a likely contributor to future periods of market illiquidity. 

We should remember that when then Fed Chairman Bernanke spoke of removing the securities purchase program in mid-‘13, he did not indicated any ‘policy-path’ for that accomplishment.  As a result, confusion and concern brought about by that unknown led to an exaggerated reaction.  Note that when the Fed in December of that year laid plans for a ‘program’ of steady reduction to that purchase program, the reaction to the news was minimal. 

On the approach of the first policy rate adjustment in more than 6.5 years, the Fed has made clear that the process of removing accommodation should be expected to be abnormally slow.  This assurance will help to limit the reaction to the initiating of the firming of the policy rate.  Although the Fed is not providing exacting detail for the timing and measurement of accommodation removal as it attends to its ‘data-dependent’ approach, we have been given strong assurances that no abrupt policy firming should be expected in the near-term. 

An articulated ‘policy-path’ for the tapering of security purchases helped to prevent an over-reaction to a tempering of additional accommodation back in 2014 (For further discussion on ‘policy-path’ see (http://thefedandinterestrates.blogspot.com/2014_01_01_archive.html).  At present, the long-standing Fed assurances that ‘even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run’, should prove supportive once the Fed begins raising the fed funds policy rate.

Until more recently, I had expected the Fed to move forth with its initial reduction in monetary policy accommodation by raising the fed funds policy rate at this June FOMC meeting.  While, I still believe that to be the best policy decision, the recurring distraction from another single winter quarter of weak GDP however has likely contributed at least an additional modicum of caution on the part of FOMC participants that will leave them prepared to postpone the initiation of policy rate firming. 

We advise listening carefully to clues that would place the July meeting more squarely on the table for the first policy rate move.  This is the main risk that attends this meeting.  The market has priced less than 2 policy rate firming (of 25 bps per) for this year.  Should market participants come to give greater expectation to a July start for policy firming, the front end of the yield curve could have a significant adjustment.  At the same time, we would ready in the event there is an excessive over-reaction out the curve to such news as this would provide additional positioning opportunity.

Finally, some economic agents have become sensitive to the reduced level of liquidity in the fixed income markets as Basel III initiatives have caused banks to scale back participation.  As a likely offset to this reduced bank participation, we should expect that the initiation of reduction in accommodation, will itself provide some benefit from increased policy transparency.  Currently with policy neither increasingly more accommodative nor reducing the level of accommodation, economic agents are less willing to move forward with spending and investment plans until such time as a more confident assessment can be made about the future for policy rates.

Counter-intuitively, even a small move forward in the process of policy firming could provide a boost to economic growth as economic agents become more confident in their assessment of future policy rates.  Especially at current low levels of policy rates, a greater conviction on the part of economic agents in their ability to forecast forward rates should be expected to outweigh the impact from marginally higher policy rates. 

        
At This Meeting
  • 2015 GDP growth likely to be lowered from 2.3%-2.7% in SEP
  • Current economic outlook to be upgraded in Statement
  • Expect more forceful acknowledgement that ‘Every Meeting is Live’
  • SEP 2015 Year-End fed funds still 0.63%

Monday, April 27, 2015

FOMC Report April 28-29, 2015



Data Dependent at Cost of Transparency

Data dependency is the Federal Reserve’s primary guidance at this juncture.  Unfortunately, we have learned following the March FOMC meeting that Fed communication may be a poor guide to understanding their interpretations of that data’s monetary policy implications.  The level of misunderstanding of the Fed’s interpretation of current and unfolding conditions was arguably greater than at any time over the last 5 years.

Former Fed Chairman Ben Bernanke once remarked that market movement following the FOMC statement release gives a good indication of how transparent the Fed has been.  Using that as a measuring stick, the market clearly indicated that the Fed had not been transparent in their communications in the run-up to the March FOMC meeting.  Not once in the last 5 years had the rolling 5th Eurodollar futures contract (then EDM6) seen as large a gain during the FOMC statement release session.  In fact, there had never in the last 5 years been any instance prompting yields at that part of the curve to fall as much in one day. 

Data dependency has always been a guiding principle for the Fed.  During periods of policy transition from excess accommodation to lesser amounts thereof, a situation most anticipate we are on the eve of, the Fed can be expected to have waited long enough before initiating the removal of accommodation that there shall be a longer uninterrupted period of policy progress.  Similarly, the Fed has shown a tendency to allow policy measures to eventually reach more restrictive levels from which a longer period of uninterrupted progress toward easier policy conditions result.  It is during those two monetary policy regimes (easing and tightening) where periods of unexpected economic data are less likely to dramatically impact interest rate projections or other asset prices. 

Currently, U.S. monetary policy resides in the valley between easing and tightening policy regimes and at this juncture, economic data offers its greatest market moving impact.  At this time, an economic release like the recent disappointing employment report can have outsized impact on interest rate projections and asset pricing compared to the response a similarly surprising report might cause in the midst of a policy regime (tightening or easing).  

There has been a significant reduction in the level of participation in the interest rate markets over the last month or so and this cannot be attributed solely to the reduction in participation by banks as this class of users has been quiet for some time.  Instead, it may be the added confusion brought by the Fed which has prompted traders to refrain from active participation until such time as economic data more conclusively points to the need to ‘normalize’ policy. 


At This Meeting

·         In general, the Statement is expected to be largely unchanged from the March FOMC.
·         The Statement may acknowledge the weaker March jobs number.
·         It may also indicate that inflation has not fallen further. 
·         It may acknowledge recent weaker production data.


More useful information from this meeting will come from the April FOMC Minutes released on May 20th.   

Sunday, March 15, 2015

FOMC Report March 17-18, 2015



·         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.