Keep Your Eye on the Fed, not the D.C. Circus
On May 21st, Ringling Brothers performed their last show in the United States, but politicians have done their best to fill the void in the marketplace. On Thursday, the public’s rapt attention turned to the new “greatest show on earth”, the testimony of former FBI director, James Comey. Just like when the circus comes to town, the event was widely publicized and highly anticipated as nearly 20 million Americans tuned in to view the testimony. Financial markets correctly paid little attention to the proceedings as stocks finished the week nearly unchanged and bond markets remained firmly bid. The complacency of the bond market may be misguided, as attention will shift away from the sideshow of another congressional hearing to Federal Reserve monetary policy that is likely to continue to tighten.
Internally, ACM’s Investment Committee continues to focus discussion on the data and policy that matter most for markets: a strong earnings season for large U.S. corporations and the upcoming Federal Reserve meeting scheduled for this week. The Fed is expected to increase rates for the fourth time since the financial crisis and the third time in 7 months when they meet this Tuesday and Wednesday. The market currently assigns a 95% probability to a rate hike this week, which we believe is justified given economic fundamentals. Additionally, further detail may emerge on the Fed’s plan to reduce the $4.5 trillion balance sheet that has been built up over the course of the past 7 years. For investors, the daily drama being produced in D.C. should remain a distraction to the strong U.S. economic outlook and the need for further tightening of monetary policy in the near future.
Since 2008, the Fed has taken extraordinary measures to combat the worst financial crisis and recession since the Great Depression. A zero-bound federal funds rate, QE1, QE2, and QE3 have all helped to stave off a financial collapse, prevent deflation, and summarily support one of the longest economic expansions in recorded history. The Fed conducted these policies to nurse an overleveraged banking system back to health in support of its dual policy objectives, to maximize employment and maintain price stability. It has been a long haul for the Fed, but the labor market has recovered. U-3 and U-6 (two measures of unemployment) are back to levels consistent with historical measures of full employment, one of the Fed’s policy objectives. With one objective achieved, the Fed is shifting focus to their second policy mandate, inflation. Recent data have emboldened some inflation doves on the Fed Board of Governors given the scant signs of a rapid increase in wages or inflation exceeding the Fed’s target range. The majority of Fed governors, however, continue to see the risks of inflation caused by labor shortages as inevitable. This supports the case for a rate hike this week and additional policy actions to unwind the effects of the aforementioned extraordinary measures.
Historically, the FOMC has achieved its objectives by setting the effective federal funds rate through open market operations. Fed policy still has significant control over short term interest rates. Since their first rate increase in December 2015, LIBOR has increased 63 bps to 1.2% and 2-year Treasury yields have increased by roughly 40 basis points to 1.33%. The same cannot be said for the path of long term interest rates. Over the same time period, 10-year Treasury rates have declined by 4 bps to 2.20%. Historically, the Federal Reserve has had very little direct control over the direction of long term rates through monetary policy. However, it is within their authority to moderate the level of long term rates. Given the size of the Fed’s security portfolio, the open market committee may be able to influence the shape of the yield curve today more than has been evident in prior economic cycles. Judging by recent pronouncements from the Fed, this is a likely course of action.
The Federal Reserve currently holds $4.2 Trillion in Treasury, Agency, and MBS debt in its System Open Market Account (SOMA). SOMA’s large portfolio is the result of successive rounds of bond buying carried out over the past 7 years during three rounds of QE. The Fed desperately wants to return to conducting monetary policy using their normal tool, the Federal Funds Rate. In the release of the May FOMC meeting minutes, the official text states that “[n]early all policymakers indicated that as long as the economy and the path of the federal funds rate evolved as currently expected, it likely would be appropriate to begin reducing the Federal Reserve’s securities holdings this year.” Reducing systemic purchases of long term bonds is likely to have ramifications for interest rates and asset prices. The U.S. Treasury market is worth approximately $14 Trillion (according to SIFMA), which means the Fed owns nearly 17% of all outstanding Treasury securities. In certain Treasury issues, SOMA owns over half of all outstanding bonds. If the Fed decides to allow securities to mature and reduce principal balances over the next several years, it should drive long term rates higher based on the most basic of economic theories: aggregate levels of supply and demand drive price. Given that Treasury supply is likely to increase as the U.S. continues to run a budget deficit, demand will have to grow in a greater proportion than supply to offset the decline in demand from the Fed exit of the bond market. In order to induce increased private sector demand, it is likely that prices for long dated Treasury securities will have to fall (rates higher) to attract more buyers than are currently active in the market at prevailing interest rates. While quantitative easing has been a controversial central bank policy around the globe, supply and demand remain incontrovertible economic theory.
The political environment remains as unpredictable as ever. The circus of D.C. politics is impacting the feasibility of tax reform, infrastructure spending and other potentially beneficial fiscal policies. Investors should be grateful that monetary policy remains firmly under the control of technocrats, not politicians. However, investors would also be wise not to confuse that gratitude with a belief that a friendly Fed will support markets indefinitely. The Fed is likely to continue to tighten monetary policy on the heels of strong economic data and evidence of full employment through further rate hikes. Should the Board of Governors choose to unwind their large portfolio of assets, complacent investors in “risk-free” government bonds might be in for a fall reminiscent of an acrobat’s misstep on a high-wire.
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