Last year when the Federal Reserve finally pulled the trigger on tapering, beginning to end its massive bond buying program (QE3), the markets and so-called experts—once they realized tapering was not tightening (a massive yearlong effort in its own right)—speculated as to when the Fed would actually tighten monetary policy.
Despite the wave of speculation and analysis, there has been a pretty solid consensus around mid-2015 give or take a quarter. One thing that seems to be clear, as with the Fed’s tapering decision, is that it has taken longer than originally anticipated so that the Fed does not want to have to turn back once initiating a new policy. So caution is the watch word.
Sheryl King, Senior Director of Research for Roubini Global Economics says, “This has been an area of research and soul searching. We’ve come through our numbers and continue to think the economy is reasonably well shielded from the downturns we started to experience in global growth and more we expect is on the way. We still think that the Federal Reserve is going to be on track to raise interest rates at some point in 2015. [We anticipate] the first increase will be in the third quarter.”
The third quarter is a safe bet squarely in the middle of the consensus. Gibson Smith, chief investment officer for fixed income of Janus Capital Group, says the Fed may have cover to wait longer, though adds that there is room on either side of the consensus.
“Our view has been that the Fed has been forced into a position to be on hold for longer than the market is anticipating and longer than what has been priced into the market,” Smith says, “but I do think that there are a couple of wild cards out there that can change that view in the short term.”
The wildcards he mentioned are the precipitous drop in crude oil prices (see “Crude oil and the economic cycle,” here) and the suddenly robust jobs sector.
We spoke to Smith after the November jobs report showed a 321K increase in nonfarm payrolls. “The important component being the average hourly earnings number going up 0.4% and showing a 2.1% year-over-year rate, an indication that the labor market is on much firmer ground than the market thinks,” Smith says. “Secondarily there is a lot of talk about what is happening in the energy markets. The move in [crude] oil from $115 down to 68 is a stimulative event.”
The move in crude is an interesting wildcard as it can be viewed in two ways. Some analysts see it as giving the Fed more room because lower prices may reduce the risk of inflation. Smith has a different take. “The markets in many ways are forgetting the importance of energy as a tax or as a stimulant to disposable income. These are two wild cards that could force the Fed’s hand a little earlier than the Market is anticipating,” he adds.
Wildcards aside, there is a history of postponing the exit from extraordinary stimulus. “From talking to Fed officials and reading what Fed officials are saying to us, they don’t want to ever be in the position that Japan faced in the 1990s where they misread the signals that the economy was telling them and started to raise interest rates only to have to back off when the economy tipped back into recession after a mild tightening,” King says. “This is something that we’ve seen repeated around the world. Many [central banks] have raised interest rates and been forced to back off. They have been reversing course because the global economy and subsequent impact on their economy told them they were not ready for higher interest rates. That is the last thing that the Fed wants to do.”
Smith points out that the Fed is focused on growth and inflation. “The inflation data has been contained and we know what is happening [globally], deflation. Net net the Fed is going to be in a difficult position of having to make decisions around what is happening domestically as well as what is happening globally,” Smith says. “Japan is in the process of a major restructuring with Abenomics, the USD/JPY hit 121.50 this morning. Europe is in a deep recession and the divergence in the economic output in the periphery vs. Germany is getting a lot of attention and that becomes an issue for global growth.”
But the Fed cannot operate in a vacuum. Just as the U.S. economy is giving the all clear in terms of a policy shift, the rest of the world appears to be heading in the opposite direction.
“The Fed has to think in two veins; one, what is happening domestically and the implications of their moves on the global situation,” Smith says. “That is why the Chinese policy move [in late November] and what I think will be additional moves are very important. As a percentage of global GDP, China and the United States are important. “
However, not everyone sees Eurozone and Chinese weakness as a complication for the Fed. “In one respect it is actually helping them because it is less of a drag on the export sector,” King says. “The other aspect is the impact on the U.S. dollar as the interest rate differentials pull away from each other. The ECB policy actions are going to get more stimulative. They have been calling for QE, [which] is looking like it is going to be a Q1 event. So they are going to be expanding their balance sheet by $1 trillion, the Bank of Japan is going to continue with their policy stimulus which will mean more downward pressure on the yen. The yen will rise to 128 vs. the U.S. dollar and the euro will go to 115 by the end of next year. Even some emerging market countries will see some depreciation.”
King expects the trade weighted U.S. dollar, the value of USD vs. a basket of currencies, is going to appreciate 4-6% over the next two years, in addition to the 6% we have already seen.
When and how much
The abundance of caution has been illustrated by the fact that we have had a zero-interest-rate policy (ZIRP) for six years. When equities saw a spike in volatility this past October, fed fund futures spiked pushing its anticipation of tightening out from July to the end of the year. The market moved tightening expectations out a full quarter and they did not recover despite equities recovering to new highs.
King explains that two things had fundamentally changed. “One, we saw a fairly chunky increase in the U.S. dollar and a profound downturn in energy, so in general the whole inflation outlook is looking a lot more benign,” she says. “Even if the economy continues to do OK—3% growth, 200K job growth per month—Fed policy has more time in terms of when they need to raise interest rates and by how much. We are not entirely convinced of that because the inflation numbers are relatively low right now but the number that we are looking at suggests that this is not going to last and we are going to continue to grind towards that 2% target.”
Smith adds, “Considering we are in a ZIRP around the globe, the Fed probably has to walk very slowly and see what the reactions are. With ZIRP, currency hedging is inexpensive, when you start to incorporate bigger interest rate differentials at the front end it puts the Fed in a position that they have to factor in what type of volatility are they going to create by moving away from ZIRP.”
Both Smith and King expect the Fed to act slow and increase rates in 25-basis point increments. Kings says don’t expect an increase at every meeting like during the last tightening cycle.
“We don’t think they will be raising rates every meeting out until 2016, we’re assuming a path were they raise one meeting and then skip so they only raise once every quarter,” she says.
But with the economy growing more briskly and being five years into a recovery, it raises the question how do we move from extremely accommodative to having the ability to apply brakes?
“There is a very active debate going on within the Fed about if you wait too long you have to raises rate more quickly,” King says while explaining, “This was a deeper recession, a balance sheet recession. The financial markets are just starting to recover, the financial system is just starting to recover, the banking sector has to adjust to a whole host of new rules which basically boil down to less credit available and if the credit is available at much stricter [rules] of lending so the whole impact within that type of low interest rates sparking borrowing, sparking consumer spending, sparking income that is still not working particularly well. That is why interest rates increases are close to a year away.”
And the Fed is not completely without other tools. Throughout this period of extraordinary accommodation, many analysts feared a day of reckoning when the Fed would be forced to unwind.
The Fed, after much hand wringing by inflation hawks, was able to convince the markets that it did not have to have a massive fire sale off of its balance sheet but could hold onto to its massive accumulation of mortgage backed securities and Treasuries and simply allow them to mature.
While that is no doubt the plan, those holdings allow the Fed to address a potential overheated economy while fed funds are still relatively accommodative and without a draconian rate increase. “They haven’t officially told us that they plan to hold things to maturity. They will stop reinvesting capital, King says, while adding, “There has been no talk of outright sales [but] it remains an option. [If necessary] they could roll down their balance sheet more quickly.”
Smith doesn’t expect the Fed to sell its book but says it does provide flexibility. “They have assured us that that is not the game plan, that they are going to hold and watch but if we get into a situation where the global economy were to move in a stronger positon, the Fed would have to use other triggers but that is very far on the horizon.”
New ‘new normal
Bond guru Bill Gross coined the phrase the “new normal” a few years ago referring to an extended period of low growth. And despite anticipation of a more normal cycle in 2015, growth levels are expected to remain subdued.
“I don’t know if I would call it a new normal or the other popular catch phrase these days, ‘secular stagnation.’ What we have seen is a reasonably large slowdown in potential growth for the U.S. economy, part of it is a lower level of productivity growth and part of it is driven by demographic factors that are slowing down the population growth,” King says. “That combination has slowed potential growth down to about 2.25% on an ongoing basis, significantly slower than the long-term average of 3.5% and more profoundly slower to what we saw in the 1990s,” he says.
“Normal now is we will be happy to create 2% growth going forward,” adds King. “We will be happy if the economy is healed enough that the downside risk that we are seeing in the global economy is not going to wash up on our shores, but the economy is more fundamentally sound than it has been in the last seven years. These are the new realities that we are dealing with.”
Smith adds, “We are fortunate to have Bill here at Janus and tap into his views into the market. That view of a new normal with a lower growth trajectory and a lower return environment is still with us and will be with us for a while.”
Smith explains, “We went through a 20-year process of credit expansion in the economy that led to increased level of debt and post 2008 we started the deleveraging process. A lot of investors talk about the end of the deleveraging process and we basically healed the issue over the last seven years but it took us 20 years to get there, the deleveraging process is still in motion and as long as we continue to de-lever; both on a personal level, a company level and more importantly on a government level, that deleveraging process will hold back growth in the economy.”
Smith adds, “It is clear that the markets believe that a low growth, low inflation environment is here to stay and in a low growth, low inflation environment, risk assets tend to do well. The key word is complacency. When the market believes this great goldilocks type environment will continue for an extended period of time, it generally leads investors taking on more risk.”
Both Smith and King pointed out that there were plenty of buyers to pick up the slack left by the Fed exit from the market. “Tapering has come and gone and there has been no material upward pressure on treasury yields. Ten-year Treasuries yields are at 2.3% so I don’t think there is a lack of willing buyers in the financial markets,” Kin says. “The Bank of Japan is upping its sovereign purchases, the fact that the ECB is expected to start buying sovereign bonds is putting downward pressure on yields all over the world. We think the economy will continue to strengthen but we don’t think we will even get to 3% in 10-year bond yields by the end of 2015.”
Smith is a little more bearish on bonds. “There is a good chance interest rates will continue to move higher in 2015. The market will begin to price in bigger discounts around those changing expectations so we can see higher 10- and 30-year rates.”
Smith adds we should beware of complacency. “While we may be in an environment of low inflation or disinflationary pressure, incremental changes in that data can lead to a change in [market] sentiment fairly quickly,” he says. “When the bond market gets complacent around believing that low inflation will be with us for a long time, you don’t price risk assets appropriately and when you get that marginal change in the data it forces investors to re-price and those re-pricings can be very painful and filled with volatility.”
Sidebar: Experts give Bernanke A+
Ben Bernanke arguably (perhaps not even arguably) is the most significant Federal Reserve Board Chairman in a generation.
Bernanke has received a lot of criticism as well as praise for his extraordinary policy prescriptions in reaction to the Great Recession and it is clear that his stewardship of the Fed during this period will be analyzed and studied for decades to come.
It was interesting to see that CME Group name Bernanke its 2014 Melamed-Arditti Innovation Award winner (formerly the Fred Arditti Innovation Award). Typically the award goes to someone whose accomplishments are validated over time. For many the book is still out on Bernanke but not our experts.
“He was probably the best person for the job when the financial crisis hit,” says King. “He was a realist, he engaged in the types of expansionist policies that were necessary in order to support the economy. Are we going to Monday morning quarterback it and say ‘did he get everything right?’ Time will tell whether everything was wise but the spirit of what he did—recognizing the credit collapse and [knowing] if you don’t get in front of it [it could ] have a profound scarring impact on the economy that can persist for a decade or more—was the right policy prescription.”
Smith gives Bernanke high marks. “We look back on some of the policy moves he made and there was a tremendous amount of criticism,” Smith says. “But here we sit at the end of 2014 looking back on the crisis and markets are functioning fluidly, we are in a better position than where we were. I give Ben Bernanke an A+ on execution and an A+ on working through one of the most critical periods in the financial markets that our children are going to read about. We have the benefit of hindsight but he was just trying to make sure that markets wouldn’t cave in on themselves.”
As noted above, however, the story of the 2008 credit crisis in not over. “It will be fun to watch Janet Yellen work through the process of exiting this unconventional policy,” Smith says. “Ben Bernanke had a difficult job; Janet Yellen has an even more difficult job.”