The market is giving very low odds for a hike at the Fed’s March meeting (roughly a one in three chance) which seems about right, though I’d probably take that even lower. The odds shoot up down the road with December Fed Fund futures at 1.15 percent—implying two hikes left for this year. This is somewhat at odds with the Fed’s own sense of the dot plot and Fedspeak to the effect that three hikes should be in the cards. However, the Fed has been habitually over-optimistic about growth and removal of accommodation throughout this crisis; it’s appropriate for the market to take the more cautious view.
Yellen (who remains in charge this year) has just opined that the next hike depends on the economy “over coming months.” March seems a wee bit too close to make a strong judgment for a hike. It is interesting and notable to see what the Fed is curious ("concerned" might be the better term) about as the Trump presidency and all its oddities unfold.
One thing they referenced several times with increased frequency is the dollar and slow global demand. This clearly has disinflationary implications putting a move as early March in reliable doubt. A second thing is the unknown of fiscal policy. Even in the most optimistic scenario from a stimulative standpoint, fiscal measures take a while to have an impact. It’s probably not reasonable to expect much stimulus until later in the year at the earliest, especially on any spending plans.
Look for CPI to bounce further in coming months due to at the very least base effects and the contribution from higher oil prices. (This dovetails with bearish seasonal tendencies for interest rates, by the way). That, along with the low level of unemployment, gives the Fed ample cover to hike later in Q2 and beyond per their own expectations and, it seems, predilection. The very nature of base effects means they are limited; the question is whether gains in inflation will come from non-energy areas. Consider that the latest read on core PCE prices (the Fed’s preferred measure of inflation) dipped a bit to 1.4 percent in November, well below their target.
With two hikes priced in, it will take more data and understanding of fiscal policies to price in, say, three or more. Base effects will subside and the dollar’s strength should serve as some inhibition to a continued rise in inflation, which leaves it to the incoming data to provoke the Fed further or not.
A sideshow to the big show of Fed hike has been the talk from several FOMC members about reducing the Fed’s balance sheet which means selling bonds. Before I go into this any further, let me say that I don’t see this as a "risk" this year or until the Fed has hiked at least three more times if then.
Why do I see this as a distant risk? First, with the potential for fiscal stimulus we have the consequence of a deeper Federal deficit and more bond issuance as a result. The new Treasury Secretary has indicated that he’d consider longer-term issuance, perhaps 40-year bonds, but in any event the result for coupon and bond issuance would mean upward pressure on yields. The Fed at this stage would not want to add to that potential by reducing their balance sheet.
If and when they choose to reduce said balance sheet, they are likely to go very gingerly. In context, the Fed has $195 billion of Treasuries maturing in 2017. The MBS reinvestments are bit more difficult to grasp—they’ve been running around $30 billion per month, but that’s likely to come down according to my friend Lou Crandall of Wrightson. He relays that it could drop to $20 billion with reduced Principal and Interest payments, presumably due to higher rates.
The Fed could alter what it’s buying with the maturing paper, which would have an impact on the curve. For instance, the CB could buy shorter paper in an effort to reduce the duration of their SOMA holdings. This would tend to create some steepening pressure on the curve as the private sector would have to buy the additional long end supply the Fed wouldn’t be buying. The same holds true if the Fed were to reduce its purchase of MBS; private investors would be the ones to absorb the supply, all long duration, and so drive mortgage rates at least a bit higher.
There is no doubt the Fed would like to do this, reduce its balance sheet. I doubt the economy would like it as it would put upward pressure on rates to an extent we can’t really forecast (depends on many moving parts, monetary- and fiscal-policy wise). That said, higher rates, say 10-year Treasuries over 3-3.25 percent, won’t sit well with the housing market or, I suspect equities. Yet, bond strategists are always skeptical of stocks; it’s our nature.
Another tangent of relevance is the state of money supply and velocity. Velocity (the rate at which money turns over in the U.S. economy) has been dropping like a stone. It stands at 1.44, the lowest level since about 1950, and has fallen over 4 percent YoY. At its peak in 1997, it was 2.2. In a nutshell, this suggests that the private sector was, in the words of one Fed study, ‘hoarding it.’ Weakness in velocity correlates with low inflation; there are no signs it's picking up.
There are ample excuses for the decline in velocity even as money supply (M2) rose during the QE episodes. Economic uncertainty was one of them; people wanted to stay liquid. Even low interest rates may have been an excuse as people needed to save more to offset low returns (ironic, no?). Yet another element is lack of financial innovation post crisis. Financial innovation would tend to create liquid alternatives to holding money. Whether through risk aversion or regulation, there’s been painfully little innovation which in turn has contributed to the reduction in velocity.
David Ader is the Chief Macro Strategist for Informa Financial Intelligence.
