INSIGHT
VIEWPOINT
The Fed, Going Forward
BRIAN SMITH | MARCH 23, 2017
In 2015 and 2016, the Fed waited until December to get in the first and only hike of
both years. In 2017, the Fed has already hiked once by March. What is the rest of the
year likely to bring?
Expect Multiple Hikes This Year (Seriously This Time)
Brian J. Smith
Senior Vice President
U.S. Fixed Income
Brian Smith is a Senior Vice President
in the U.S. Fixed Income Rates group. In
conjunction with the generalist portfolio
managers, Mr. Smith helps determine and
implement duration and curve positioning
across fixed income portfolios. While
specializing in interest rate derivatives, he
also trades Treasuries, agencies, TIPS, and
futures. Prior to joining TCW in 2011, Mr.
Smith was a fixed income trader at Barclays
Capital. Previous to this, he was a fixed
income trader at Lehman Brothers. Mr. Smith
holds a bachelor’s degree in Economics and
Mathematics from Yale University.
The effective Federal funds rate still remains well below even pessimistic expectations
of the short-term equilibrium nominal interest rate (r* + inflation). If the shortterm real interest rate (r*) is 0%, and the inflation target is 2%, the neutral Federal
Funds rate projects to 2%. Despite having gotten in three quarter-percent hikes
off the 0.25% level, the current Federal funds target rate at 1% remains 100 basis
points accommodative to 2%. Thus, one can argue that the Fed is not so much
aggressively tightening monetary policy as they are making monetary policy slightly
less accommodative.
The stated reason for the Fed’s newfound determination to raise rates is that the
economy continues to progress toward its dual mandate. The labor market continues
to tighten as the U.S. economy creates roughly 200,000 jobs per month. Inflation
is also trending higher, with headline inflation rising due to base effects of oil and
core inflation prints (ex-food and energy) finally approaching 2%. Thus, the Fed can
continue hiking rates for price stability while still promoting full employment.
Many FOMC members have publicly reinforced this hawkishness by stating they
expect to hike at least three times this year, yet Chair Janet Yellen’s opinion matters
most. Yellen’s own “optimal control” theory postulated that rates should be kept
VIEWPOINT
The Fed, Going Forward
The Pending Transition from Rate Hikes to Balance Sheet
Reduction
lower for longer to ensure a stronger recovery, but then
ultimately raised more aggressively once tightening begins
to make up for this easier period. Have we finally entered this
more aggressive tightening period? Like in a poker game,
one must read the player and not the cards. The key is to
understand Yellen’s thinking.
The Fed’s balance sheet currently sits at $4.5 trillion. Prefinancial crisis it was less than $1 trillion. The balance sheet
expanded through Treasury and mortgage-backed securities
(MBS) purchases, which materially increased risk asset
pricing through the portfolio balance channel. With the
Fed now looking to remove extraordinary monetary policy
accommodation, it makes sense to reduce the balance sheet.
Yellen is Already Thinking of Her Legacy and Acting
Accordingly
With less than one year until her chair term is up and she
is likely replaced by President Trump, Janet Yellen’s recent
speech “From Adding Accommodation to Scaling It Back”
had the feel of an outgoing chair looking to defend her
legacy. After detailing lengthy (and some might say dubious)
explanations as to why the Fed only hiked once in 2015 and
2016, she implied that in 2017 the Fed is more resolute to
proceed on its intended hiking path, or in her words, “the
process of scaling back accommodation likely will not be as
slow as it was during the past couple of years.”
Yet, if expanding the balance sheet was seen as an alternative
to cutting rates at the zero lower bound, shrinking the balance
sheet must be similarly seen as an alternative to hiking rates.
Balance sheet reduction represents a secondary monetary
policy brake pedal, with traditional rate hikes being the
primary brake pedal. When the Fed transitions to reducing
the balance sheet, it may temporarily pause on rate hikes to
prevent from pushing two brake pedals simultaneously.
Numerous Fed officials have hinted towards such thinking.
Minnesota Fed President Neel Kashkari dissented against
hiking in March in favor of alternatively announcing a
schedule for balance sheet reduction and seeing how the
market digested it. Yellen, herself, postulated in a footnote to
a recent speech that the monetary policy tightening impact
of reducing the balance sheet may be equivalent to two rate
hikes. Finally, Philadelphia Fed President Harker declared
in January that “when [the Fed funds rate is] at or above 100
bps, I think it is time to start serious consideration the first
stopping of reinvestment and then over a period of time
unwinding the balance sheet.”
Going inside the mind of Janet Yellen, the primary criticisms
she has faced during her reign as Fed chair have been her
unwillingness to normalize interest rates and her reluctance
to shrink the balance sheet. If Mrs. Yellen wants to give herself
the best odds of being remembered more fondly in the history
books, she needs to address these concerns before her chair
term ends. Getting in a couple of rate hikes and announcing a
schedule for commencing balance sheet reduction before the
end of the year would do just that, even though many will still
claim it is too little, too late.
If there are unforeseen economic shocks or fiscal policy
breakdowns during the year, then this course of action can
quickly change, but assuming the status quo, the Fed’s
trajectory appears largely set. Announcing balance sheet
reduction before leaving would also invoke strong similarities
to Ben Bernanke’s exit as chair when he announced the
tapering of asset purchases in his final month before leaving
his successor (Yellen) to handle the logistics of executing
the plan.
Scars from the market taper tantrum of 2013 have led the
Fed to telegraph monetary policy actions well in advance to
prepare the market. The constant harping on balance sheet
reduction by committee members in public speeches signals
that action is imminent, and the inherent cautiousness of the
Fed implies it will likely temper concurrent rate hikes. Expect
balance sheet reduction to be announced later this year and
initiate with stopping MBS reinvestment as mortgage spreads
are tight, the housing market is strong and MBS securities
were not traditionally a part of the Fed’s balance sheet. 2
VIEWPOINT
The Fed, Going Forward
For example, the 2s10s Treasury curve is projected to flatten
60 bps over the next 2 years from 115 bps to 55 bps. This is
due to the forwards projecting the 2-year rate to rise 107 bps
from 1.25% to 2.32%, while the 10-year rate only rises 47 bps
from 2.40% to 2.87%:
Investment Implications:
If Fed balance sheet expansion lifted risk asset pricing, then
balance sheet reduction should reduce risk asset prices. Yet,
monetary policy is no longer the only game in town as fiscal
policy stimulus and geopolitical concerns are now in play
amid what appear to be late-cycle economic dynamics.
Duration in fixed income portfolios need not be shunned
simply because the Fed is hiking. A perfect example of this
was shown last week, when the Fed hiked and rates rallied
10 bps across the curve. In a low yield environment, duration
must be analyzed by comparing underlying carry and rolldown
dynamics against hiking expectations already been priced into
the implied forwards.
From a U.S. rates perspective, Chair Yellen’s legacy concerns
and corresponding hawkishness would traditionally bias frontend rates higher as more hiking expectations are priced in.
Yet, the pending transition to balance sheet reduction should
temper the extent to which the Fed will hike rates.
The market is currently pricing in just less than two additional
hikes in 2017 and two hikes in 2018. If this pace materializes,
the front-end of the rates curve is fairly priced despite optically
low outright yield levels. Front-end rates valuation is driven
by positive carry and roll down the curve, as they provide
a natural buffer against higher yields within a fixed income
portfolio.
Conclusion:
To understand the Fed in 2017, realize that Janet Yellen is
looking to defend her legacy as chair. This cover-your-tail
philosophy entails a more hawkish response function. Yet,
the transition to balance sheet reduction will temper the
number of traditional rate hikes, as balance sheet reduction
represents an unknown monetary policy tightening avenue. In
2018, President Trump’s pending appointments to the board
will shape future Federal Reserve policy direction. Yet, for the
remainder of this year, Yellen has revealed an inclination to
make up for lost time. While the kneejerk reaction is to short
duration, investors should closely examine carry and forwards
to optimally invest fixed income portfolios.
The forward rates curve is also very flat, which shows that
the market has already priced in higher front-end rates in the
future. Investors should only avoid front-end duration if they
expect rate hikes to be materially greater than what the market
has already priced into the forwards.
Forward Yields:
2-year Treasury (%)
5-year Treasury (%)
10-year Treasury (%)
30-year Treasury (%)
Forward Curves:
2s10s Curve
5s30s Curve
Today
1.25
1.94
2.40
3.01
Today
1.15
1.07
1-year Forward
1.80
2.35
2.67
3.13
1-year Forward
0.87
0.78
2-year Forward
2.32
2.64
2.87
3.22
2-year Forward
0.55
0.58
3-year Forward
2.62
2.81
3.02
3.29
3-year Forward
0.40
0.48
Source: Bloomberg
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