TRILOGY’S WORLD REPORT
September 2015
THROUGH THE WINDSHIELD:
MARKET IMPACTS OF THE FED’S STEALTH TIGHTENING
Over the past year, we have argued that the Fed’s measured efforts to retreat from Quantitative Easing (QE) and
other unconventional monetary policy measures would represent a powerful form of monetary tightening well
before the first hike in interest rates. To make this case, we introduced our readers to the concept of shadow
interest rates, which economists have used to try to gauge changes in monetary policy when interest rates are
stuck around zero.1
The case we made about a year ago was that the months leading up to the Fed’s first rate hike will have more in
common with an actual Fed tightening cycle than is widely appreciated. Based on the shadow rate concept, exiting
from unconventional policy can be thought of as a form of “stealth tightening” that may be roughly equivalent to a
cumulative hike of more than 3% in the federal funds rate. We argued then, and continue to believe now, that the
process of normalizing interest rates would bring:






Rising market volatility well ahead of the first rate hike
Higher long-term U.S. interest rates
Pressure on equity and corporate bond prices
Pressure on REITs
A stronger U.S. dollar
Weaker commodity prices
This daunting list of the effects of Fed tightening brings to mind the old market saw: “When the Fed taps on the
brakes, somebody goes through the windshield.”2 Since a number of asset classes have recently experienced
notable turbulence, we thought it would be useful to review the shadow rate concept along with evidence that
markets have been behaving as if the Fed had already been tightening monetary policy for many months.
We will also argue that a substantial amount of effective tightening is still implied even if liftoff is delayed until
December. That, along with some significant uncertainties about how the “financial plumbing” will function as
liftoff proceeds, points to continued market turbulence in coming months. The good news is that we do not think
the higher volatility is pointing to a synchronized global recession or a Lehman-type crisis. But it is not unusual for
Fed tightening to create market volatility even if the ultimate result is to extend the length of an economic
expansion by preventing an unacceptable acceleration in inflation.
In short, be prepared for more volatility even though the ultimate outcome of Fed exit should be benign.
A BRIEF REVIEW OF THE SHADOW RATE CONCEPT
When a central bank’s policy rate gets stuck around zero, it no longer provides much information about how
monetary policy may be affecting the economy and financial markets. This is especially true when policymakers
resort to other powerful monetary measures like large-scale asset purchases and forward guidance about how long
they will keep the funds rate near zero. The challenge is how to measure the impact of those types of policies in a
way that is comparable to the past when interest rate changes told investors most of what they needed to know.
1 See
2
“Shadowing the Central Banks,” Trilogy’s World Report, August 2014
We do not know the exact origin of this market lore, but the first reference we could find came from a November 1941 New
York Times editorial which observed: “It is necessary to put the brakes on inflation; but there is such a thing as jamming on the
brakes so hard that the passengers go through the windshield.”
TRILOGY’S WORLD REPORT
Fischer Black proposed an answer to that challenge in 1995 when he introduced the concept of the shadow
interest rate.3 His key insight was that cash has an option value even when interest rates are near zero.
Specifically, cash provides savers with an alternative to losing money in a deflationary environment. That option
value can be modeled using standard option pricing theory. By stripping out the influence of that option value on
interest rates along the yield curve, a hypothetical “shadow yield curve” can be estimated.
We show an example of the shadow rate concept in Exhibit 1. We also show in Exhibit 2 how a negative shadow
rate can be extrapolated from non-zero interest rates that can be observed at longer maturities further out the
yield curve. Both of these illustrations are based on research on the shadow rate concept by economist Leo
Krippner of the Reserve Bank of New Zealand.4
Intuitively, the shadow rate becomes negative when large-scale asset purchases (or other unconventional
measures like forward guidance) push short-term and intermediate-term interest rates lower than they otherwise
would be. These effects do not necessarily result in negative interest rates, but are reflected in extremely low, but
non-zero interest rates than can be observed along the yield curve. Conversely, the shadow rate becomes less
negative when the central bank scales back asset purchases or forward guidance, permitting some upward
pressure on rates. The process of backing away from large-scale asset purchases has been referred to as “tapering”
in the U.S., and some of its tightening implications were evident in the phrase “taper tantrum” that described
market disruptions in 2013.
WHAT DOES THE SHADOW RATE CURRENTLY SAY ABOUT U.S. MONETARY POLICY?
We show in Exhibit 3 an estimate of the shadow federal funds rate that is published regularly by the Federal
Reserve Bank of Atlanta.5 As shown, that estimate suggests that the Fed’s unconventional measures had created a
shadow funds rate of minus 3% as of May 2014. In other words, not only had the Fed created a “cash is trash”
mindset among investors by pegging the funds rate close to zero, they had also suppressed short-term interest
rates further out the yield curve through asset purchases and forward guidance. The Fed’s unconventional
measures also had weakened the U.S. dollar and encouraged investors to embrace a wide range of risky assets and
to “stretch for yield” in both domestic and international credit markets. That much is well known about Fed policy.
What we believe has been less well appreciated, which is also clear from Exhibit 3, is that the move toward liftoff
represents an effective tightening of more than three percentage points. That would reflect a move in the shadow
funds rate from minus 3.0% in May 2014 to about 0.4% by the time liftoff finally occurs. Most economists now
expect liftoff to occur sometime this year in the September through December time period. According to the
Atlanta Fed measure, the shadow rate had risen to minus 0.9% at the end of August, which implied an effective
tightening of about 2.1% since May of 2014. It is worth noting that the Atlanta Fed’s measure implies that roughly
another 1.3% of tightening will occur by the time of liftoff if the shadow rate is to move from minus 0.9% to
positive 0.4%.
3 Fischer
Black, “Interest Rates as Options,” The Journal of Finance, Vol. 1, No. 7, December 1995
4 For
a non-technical overview of the shadow rate concept, see Leo Krippner, “A Model for Interest Rates Near the Zero Lower
Bound: An Overview and Discussion,” Reserve Bank of New Zealand Analytical Note Series, September 2012. For greater
technical detail, see Leo Krippner, “Documentation for United States Measures of Monetary Policy, September 30, 2014 found
on the Reserve Bank of New Zealand website.
5
The technical basis for the Atlanta Fed’s shadow rate estimates can be found in Cynthia Wu and Fan Dora Xia, “Measuring the
Macroeconomic Impact of Monetary Policy at the Zero Lower Bound,” Draft of July 19, 2014. A non-technical discussion of the
work of Wu and Xia can be found in Dee Gill, “Is Fed Intervention Effective: Ask the Shadow Rate,” Capital Ideas, Chicago Booth
School of Business, June 17, 2014.
TRILOGY’S WORLD REPORT
Have financial markets acted like the Fed has been tightening policy? We think the answer is yes. Consider the
checklist we published a year ago on the potential effects of U.S. monetary tightening. This list is based on
economic research summarized in Exhibit 4 which uses the shadow rate concept to estimate the impact of U.S.
monetary shocks on various asset classes.6






Rising market volatility well ahead of the first rate hike? Check.
Higher long-term U.S. interest rates. Not yet.
Pressure on equity and corporate bond prices. Check.
Pressure on REITs. Check.
A stronger U.S. dollar? Check.
Weaker commodity prices? Check.
Five out of six checkmarks is not bad – in line with the maxim “if it walks like a duck and quacks like a duck, it’s
probably a duck.”
GLOBAL EQUITY SENSITIVITY TO RISING SHADOW RATES REFLECTS “STEALTH TIGHTENING”
Moreover, we can offer other compelling, market-based evidence that global financial markets have been acting as
if the Fed had already begun a tightening cycle. This evidence is based on work by Trilogy’s risk analysis team to
track the implications of a rising shadow rate on a long-short portfolio of global equities. That long-short portfolio
was based on equities selected on the basis of their high degree of sensitivity to changes in the shadow rate, based
on the shadow rate data published by the Atlanta Fed.
Using three years of monthly data through July 2014, our risk team created equally weighted 100 stock portfolios
of stocks whose monthly percentage change had the highest and lowest correlations with monthly changes in the
shadow funds rate. The sector and regional composition of the Rising Shadow Rates Portfolio and Falling Shadow
Rates Portfolio are shown respectively in Exhibits 5 and 6.
As is evident from the data, the Rising Shadow Rates Portfolio favored stocks in the consumer discretionary and
financial sectors while underweighting stocks in the consumer staples, energy, and industrials sectors. In terms of
regions, it overweighted Japan and underweighted Europe. In contrast, the Falling Shadow Rates Portfolio favored
the energy, materials, and utilities sectors, while underweighting consumer discretionary, financials, and
information technology. It also favored Europe and Canada over the U.S. and Japan.
Note that these sector and regional tilts are not an assessment of the overall attractiveness of those sectors or
regions. Instead, they are based on the fact that in a universe limited to the top 100 and bottom 100 most
sensitive securities, those regions and sectors are where the names with the greatest shadow-rate sensitivity are
concentrated. For example, with respect the Falling Shadow Rates Portfolio, the preference to the materials sector
simply reflects the fact that gold-mining stocks appeared (along with the gold price) to be major beneficiaries of
falling shadow rates, while the reverse was true when shadow rates began to rise.
Exhibit 7 shows how the Long-Short Shadow Rate portfolio has performed since our risk team started tracking
it at the end of August 2014. As shown, it has returned over 22% in the subsequent year with only modest
volatility (6.7%) and very low correlation to the MSCI World Index of developed market (DM) global equities.
From our perspective, that is solid evidence that market dynamics have evolved as if the Fed has already been
in a tightening cycle.
6 See
E. Claus, I. Claus, and L. Krippner, “Asset Markets and Monetary Policy at the Zero Lower Bound,” Discussion Paper Series,
Reserve Bank of New Zealand, July 2014.
TRILOGY’S WORLD REPORT
Indeed, a goal of the economists who have pursued this line of research is to be able to monitor the real-world
impact of unconventional Fed policies at a time when short-term interest rates have “flatlined” for many years and
provided no information about important dimensions of Fed policy. We think the behavior of the simple Long-Short
Shadow Rate portfolio is evidence that the shadow rate concept and measurement methods have genuine merit for
those struggling to understand how monetary policy works during an era of zero interest rates and powerful
unconventional measures.
HOW FAR WILL THE SHADOW RATE RISE?
As we noted earlier, the shadow rate story is far from over. Assuming that the new target range for the Federal
funds rate after liftoff is 0.25% to 0.50%, the midpoint of that range would be 0.37%. That compares to the endAugust Wu-Xia estimate of the shadow rate of minus 0.92%. So in rough numbers, a move from minus 0.9% to
about 0.4% would represent an effective tightening by liftoff of 1.3%, which is decidedly non-trivial.
In view of recent market fragility and the fact that inflation expectations are quite depressed, we think one reason
for the Fed to delay tightening until December is that it is not clear that the equivalent of nearly 1.3% of tightening
is needed at this point. Indeed, the Fed funds futures market now puts an implied probability of a September
tightening at only about 30% as shown in Exhibit 8, whereas the probability of liftoff by the Fed’s December 17th
meeting is nearly 60%.
One popular view among some market observers is that the Fed will want to move quickly – just to get through the
first hike – and then go on hold for an extended period. In other words, “one and done.”7 The shadow rate concept
would argue against this view: why tighten the equivalent of 1.3% if inflation expectations remain subdued while
the economic data is ambiguous?
And even though the shadow rate concept might argue against a September liftoff, it also suggests that the idea of
“one and done” might be deeply flawed from a different perspective. Consider Exhibit 9, for example, which shows
the long-term history of the Fed funds rate relative to the San Francisco Fed’s estimate of the real natural rate of
interest (which we have adjusted to a nominal rate by adding back in an estimate of expected inflation).8
The San Francisco Fed has estimated that the real natural rate of interest has been in a multi-decade decline, such
that the current real natural rate of interest is estimated at minus 0.1%.9 Adding back in annualized inflation of
about 1.4% – the 3-year moving average of PCE inflation – implies a nominal natural rate of interest of 1.3%. As is
evident from Exhibit 9, in previous rate hiking cycles the Fed funds rate has always gone well above the natural rate
of interest during a tightening cycle. So the idea that the Fed will push the funds rate to 0.4% and then stop for an
indefinite period seems very much out of line with historical experience.
7
A critical reference to the “one and done” view can be found in Larry Summers, “Why the Fed Must Stand Still on Rates,”
www.larrysummers.com, September 9, 2015. Summers’ begins his argument with a point that is consistent with our perspective,
noting that “First, markets have already done the work of tightening.” He also forcefully dismisses the “one and done” argument
as follows: “Fourth, arguments of the ‘one and done’ variety or arguments that the Fed can safely raise rates by 25 BP as long as
it’s clear that there is no commitment to a series of hikes are specious. If as some suggest a 25 BP increase won’t affect the
economy much at all, what is the case for an increase? And when the same people argue that 25 BP will have little impact and
that it is vital to get off the zero rate floor, my head spins a bit.”
8
The definition of the natural rate of interest used by the San Francisco Fed is “the real fed funds rate consistent with stable
inflation absent shocks to demand and supply.” See John Williams, “The Natural Interest Rate,” FRBSF Economic Letter, October
31, 2003.
9
See John Williams, “The Decline in the Natural Rate,” Presentation to the National Association of Business Economists, January
3, 2015. Regular updates to the natural rate estimates can be found at: http://www.frbsf.org/economicresearch/economists/john-williams/Laubach_Williams_updated_estimates.xlsx
TRILOGY’S WORLD REPORT
We would also point out that the shadow rate and the actual funds rate are identical by construction once the
shadow funds rate rises to 0.25%. Accordingly, the key question after liftoff becomes: at what level the funds rate
will peak? For reference, we have plotted in Exhibit 10 the historical gap between the natural rate and the
combined actual funds rate/shadow funds rate measure. As is evident, since the mid-1980s the funds rate has
almost always gone to around 200 basis points or more above the natural rate during tightening cycles. So if the
natural interest rate is now about 1.3%, it would not be surprising to see the funds rate move to 3.25% or higher as
the tightening cycle proceeds.
As shown in Exhibit 11, 3.25% represents the lower end of the range of where FOMC members expect the funds
rate to end up when the Fed is finished tightening monetary policy. The median projection is for a longer-term
funds rate of 3.75%. So there remains a substantial gap between where FOMC members expect the funds rate to
go in coming years compared to market expectations. For example, Fed funds futures markets currently anticipate
that the funds rate will move up to only 1.375% by the end of 2017 compared to the median FOMC projection that
it would move to 2.875% by that time.
To be sure, there has been financial fragility in overseas markets that may argue for a lower terminal funds rate.
But as shown in Exhibit 12, it is also notable that the U.S. unemployment rate has come down steadily in recent
years, despite a variety of shocks from overseas including the sovereign debt crisis in Europe and a major slowdown
in China’s economy. Although pressure on wages has remained subdued despite the decline in unemployment, the
potential for rising wages to put upward pressure on core inflation is clearly a concern that is front and center
among FOMC members at this point.
Essentially, the shadow rate concept results in a good news, bad news story for investors. The good news is that a
fair amount of effective tightening has already occurred in a stealth manner as the Fed backed away from largescale asset purchases and forward guidance on rates. Also, as is evident from Exhibit 9, even after liftoff the funds
rate will still be well below the estimated neutral rate of 1.3%. So monetary policy will be far from restrictive, even
though it will no longer be ultra-accommodative. The bad news is that a substantial amount of additional tightening
will probably be needed over the next few years, suggesting that the checklist of effects of monetary tightening will
remain operative for some time to come. In the end, if appropriate policy sets the stage for an extended, noninflationary expansion, that should be good news for long-term equity investors even at the cost of some near-term
turbulence.
MIND THE PLUMBING
A separate but related issue to the potential for market turbulence as liftoff approaches is not the degree of
tightening, but the kind of tightening that will occur. As noted in research by Credit Suisse economists Zoltan Pozsar
and James Sweeney, the Fed’s exit from zero rates could be turbulent not just because they have never tried to
raise rates from such low levels before, but for three separate reasons:10
 First, they will raise rates using new tools.
 Second, the money flows that liftoff will generate, both on and offshore, will dwarf those involved in past
hiking cycles.
 Third, liftoff will occur in a completely redesigned financial system, with bank balance sheets now subject to
liquidity and funding rules that have never been stress-tested in a hiking cycle before.
10 Zoltan
2015.
Pozsar and James Sweeney, “A Turbulent Exit,” Global Money Notes #2, Credit Suisse Economic Research, August 28,
TRILOGY’S WORLD REPORT
Their arguments are highly technical, but their central metaphor is compelling. As shown in Exhibit 13, they see the
Fed’s key new tool – RRPs, or “reverse repurchase agreements” – as a kind of “monetary Hoover Dam.”11 The point
is that in a banking system currently awash in excess reserves, RRPs are a tool that will let the Fed redistribute
liquidity away from banks and to money market funds. As shown in Exhibits 14 and 15, the Credit Suisse
economists posit for the sake of illustration that $2 trillion of deposits could leave the banking system and migrate
toward money market funds in the year after liftoff.
Will banks that see large deposit outflows have to bid aggressively for funds in wholesale markets to meet
regulatory requirements for High Quality Liquid Assets (HQLA)? Or will they have to sell U.S. Treasuries or agency
Mortgage Backed Securities to do so? And could those potential U.S. Treasury sales result in upward pressure on
the U.S. dollar by satisfying foreign exchange reserve managers’ strong demand for safe, short-term U.S. dollar
instruments?
No one really knows how the logistics will work once large and presumably very fast money flows from bank
deposits to money market funds get underway, or how those flows will interact with the complex set of new
liquidity and funding rules that have been put in place in the zero-rate environment.
As they say about military matters, “amateurs talk strategy, professionals talk logistics.” So it is interesting to us
that the professionals on bank funding and money market logistics at Credit Suisse have reached a similar
conclusion to the shadow interest rate analysis: Get ready for a turbulent exit.
William Sterling
Chief Investment Officer
Trilogy Global Advisors, LP
(212) 703-3100
[email protected]
11
A reverse repurchase agreement, also called a “reverse repo” or “RRP,” is an open market operation in which the Fed sells a
security to an eligible RRP counterparty with an agreement to repurchase that same security at a specified price at a specific
time in the future.
TRILOGY’S WORLD REPORT
IMPORTANT INFORMATION
The opinions expressed above are those of Trilogy Global Advisors, LP and are subject to change. There is no
guarantee that predictions or expectation will come to pass. This material does not constitute investment advice
and is not intended as an endorsement of or recommendation to purchase or sell any specific investment or
security.
Investment involves risk. Investing in the securities of non-U.S. companies involves special risks not typically
associated with investing in U.S. companies. Foreign securities tend to be more volatile and less liquid than
investments in U.S. securities, and may lose value because of adverse political, social or economic developments
overseas or due to changes in the exchange rates between foreign currencies. In addition, foreign investments are
subject to settlement practices, and regulatory and financial reporting standards, that differ from those of the U.S.
The risks of foreign investing are heightened for securities of companies in emerging market countries. Emerging
market countries tend to have economic structures that are less diverse and mature, and political systems that are
less stable, than those of developed countries. In addition to all of the risks of investing in foreign developed
markets, emerging market securities are susceptible to illiquid trading markets, governmental interference, and
restrictions on gaining access to sales proceed.
Certain information herein has been provided by independent third parties whom Trilogy believes to be reliable.
Although all content is carefully reviewed, it cannot be guaranteed for accuracy or completeness.
Any graphs, charts or formulas shown are not and should not be used as the sole basis of making investment
decisions. There can be no guarantee that any forecast or projections will be realized or attained.
Source: MSCI. The MSCI data is comprised of a custom index calculated by MSCI. MSCI makes no warranties or
representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI
data may not be further redistributed or used as a basis for other indices or any securities or financial products. This
report has not been produced or approved by MSCI.
© 2015 Trilogy Global Advisors, LP. All rights reserved.
TRILOGY’S WORLD REPORT
EXHIBIT 1
Source: Leo Krippner, “A Model for Interest Rates near the Zero Lower Bound: An Overview and Discussion,”
Reserve Bank of New Zealand Analytical Notes, September 2012
The shadow yield curve cannot be observed directly, but can be estimated by subtracting the
option value of cash from the actual yield curve. This yields negative shadow rates.
EXHIBIT 2
Illustration of How to Estimate a Negative Shadow
Short Rate (SSR) from Yield Curve Data
Source: Leo Krippner, “Documentation for United States Measures of Monetary Policy,” Reserve Bank of New
Zealand, September 30, 2014
When short rates are near zero, a negative shadow short rate (SSR) can be estimated by
using yield curve data together with a model that strips out the option value of cash and cash
equivalents.
TRILOGY’S WORLD REPORT
EXHIBIT 3
Wu-Xia
Wu-XiaShadow
ShadowFederal
FederalFunds
FundsRate
Rate
Based on the Wu-Xia shadow rate estimates, the move from a minus 3% shadow rate in May
2014 to a positive 0.4% funds rate by time of liftoff is equivalent to cumulative tightening of
3.4%.
EXHIBIT 4
TRILOGY’S WORLD REPORT
EXHIBIT 5
Sector Weights of Rising and Falling Shadow Rates Portfolios
Percent of Total Holdings
8/29/2014
U.S. Dollar
Rising Shadow Rates Portfolio vs MSCI WorldFalling Shadow Rates Portfolio vs MSCI World
GICS Sector New
Port.
Weight
Bench.
Weight
Difference
Port.
Weight
Bench.
Weight
Difference
Total
100.00
100.00
--
100.00
100.00
--
27.00
3.00
3.00
31.00
8.00
3.00
16.00
7.00
1.00
1.00
12.12
9.62
9.78
20.77
12.07
10.91
12.53
5.63
3.30
3.26
14.88
-6.62
-6.78
10.23
-4.07
-7.91
3.47
1.37
-2.30
-2.26
6.00
5.00
18.00
13.00
7.00
13.00
6.00
16.00
4.00
12.00
12.12
9.62
9.78
20.77
12.07
10.91
12.53
5.63
3.30
3.26
-6.12
-4.62
8.22
-7.77
-5.07
2.09
-6.53
10.37
0.70
8.74
Consumer Discretionary
Consumer Staples
Energy
Financials
Health Care
Industrials
Information Technology
Materials
Telecommunication Services
Utilities
Source: MSCI, FactSet, Federal Reserve Bank of Atlanta, and Trilogy Global Advisors, LP
Key beneficiaries of rising shadow rates are concentrated in the consumer discretionary and
financial sectors, while losers are concentrated in consumer staples, energy and industrials.
Key beneficiaries of falling shadow rates are concentrated in the energy, materials and
utilities sectors, while losers are concentrated in the consumer discretionary, financials, and
information technology sectors.
EXHIBIT 6
Regional Weights of Rising and Falling Shadow Rates Portfolios
Percent of Total Holdings
Ex [Cash]
8/29/2014
U.S. Dollar
Country Region (Europe) w/ US
Total
CANADA
EUROPE
JAPAN
PACIFIC EX JAPAN
UNITED STATES
Rising Shadow Rates Portfolio vs MSCI WorldFalling Shadow Rates Portfolio vs MSCI World
Port.
Bench.
Port.
Bench.
Weight
Weight
Difference
Weight
Weight
Difference
100.00
100.00
--
100.00
100.00
--
1.00
7.00
34.00
-58.00
4.39
26.70
8.11
5.16
55.64
-3.39
-19.70
25.89
-5.16
2.36
20.00
38.00
6.00
11.00
25.00
4.39
26.70
8.11
5.16
55.64
15.61
11.30
-2.11
5.84
-30.64
Source: MSCI, FactSet, Federal Reserve Bank of Atlanta, and Trilogy Global Advisors, LP
Key beneficiaries of rising shadow rates are concentrated in Japan, while losers are
concentrated in Europe and the Pacific Rim excluding Japan.
Key beneficiaries of falling shadow rates are concentrated in Canada and Europe, while losers
are concentrated in the U.S.
TRILOGY’S WORLD REPORT
EXHIBIT 7
Performance of the Long-Short Shadow Rate Portfolio
30%
25%
20%
15%
10%
5%
0%
8/31/2014
10/13/2014 11/24/2014
1/08/2015
2/23/2015
4/07/2015
5/19/2015
7/01/2015
8/13/2015
Source: MSCI, FactSet, Federal Reserve Bank of Atlanta, and Trilogy Global Advisors, LP
Since inception on August 29, 2014, the long-short shadow rate portfolio gained over 22%
over the following year, with relatively low volatility. So the market has behaved as if
tightening has occurred.
EXHIBIT 8
Bloomberg’s Fed Funds Probability Estimates
Source: Bloomberg
Based on futures prices, the implied probability of a September 17th tightening has fallen to
28% after being higher than 50% in early August. The implied probability of liftoff in
December is close to 60%.
TRILOGY’S WORLD REPORT
EXHIBIT 9
The Actual (and Shadow) Fed Funds Rate vs
San Francisco Fed Estimate of Natural Rate of Interest: 1986-2015
10
8
6
4
2
0
-2
Actual and (post 2008) Shadow Funds Rate*
Estimated Natural Rate of Interest*
-4
86
88
90
92
94
96
98
00
02
04
06
08
10
12
14
16
Source: Atlanta Fed, San Franciso Fed, and Trilogy Global Advisors, LP
*Note: actual funds rate from 1986-2008, W u-Xia shadow rate published
by Atlana Fed from 2009m1-2015m8. Natural rate estimate by San
Franciso Fed adjusted to nominal rate using 3-year moving average of
core PCE inflation.
Reflecting forces such as technology and globalization, the estimated “natural rate of
interest” has declined in recent decades. But in tightening cycles, the funds rate tends to rise
above the natural rate.
EXHIBIT 10
Historically the Funds Rate Has Risen Well Above the
Natural Rate of Interest During Tightening Cycles
4
Federal Funds Rate (Shadow Rate)
Less Estimated Natural Rate (%)*
Funds Rate > Natural Rate
3
2
1
0
-1
-2
-3
-4
Funds Rate < Natural Rate
-5
86
88
90
92
94
96
98
00
02
04
06
08
10
12
14
16
Source: Atlanta Fed, San Francisco Fed and Trilogy Global Advisors, LP
Historically, the federal funds rate has risen to around 200 basis points or more above the
estimated natural rate of interest. That would point to a terminal funds rate of at least
3.25% in this cycle.
TRILOGY’S WORLD REPORT
EXHIBIT 11
Source: Bloomberg
The implied path for the federal funds rate based on futures prices still lies well below the
median projection by the FOMC’s “Dot Plot” survey.
EXHIBIT 12
The U.S. unemployment rate has fallen steadily in recent years, in spite of global shocks. At
5.1% in August, it now lies below the FOMC’s “central tendency” estimate of full
employment.
TRILOGY’S WORLD REPORT
EXHIBIT 13
The Hoover Dam – Think of RRPs as a Monetary Hoover Dam
Source: Credit Suisse and http://waterandpower.org/Construction_of_Hoover_Dam.html
Credit Suisse economists argue that the Fed’s new tool – Reverse Repurchase Agreements
(RRPs) – will act to create a “Hoover Dam” in dollar liquidity by redistributing bank excess
reserves into money funds.
EXHIBIT 14
Now: The Financial System with a Small RRP Facility
As a legacy of the Fed’s quantitative easing (QE), the current financial system has about $2.5
trillion in bank reserves and only $100 billion in RRPs held by money funds – namely, a small
RRP facility.
TRILOGY’S WORLD REPORT
EXHIBIT 15
The Near Future: The Financial System with a Large RRP Facility
Six to twelve months after liftoff, Credit Suisse posits that $2 trillion of deposits may leave
the banking system for money funds, requiring an RRP of $2.1 trillion – namely a large RRP
facility.
In short, the money flows that liftoff will generate, both onshore and offshore, are likely to
dwarf those involved in previous hiking cycles, with the potential for creating turbulent
market conditions.