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GIM Solutions-GMAG –
Weekly Strategy Report
30th March 2015
Liftoff 2015
A farewell to forward guidance
Chart of the Week:
Converging on 2015
This document is produced by the Global
Strategy Team within GIM Solutions-GMAG.
For further information please contact:
Editor: Patrik Schöwitz
[email protected]
Michael Albrecht
John Bilton
Michael Hood
Beth Li
Jonathan Lowe
Benjamin Mandel
David Shairp
Liftoff 2015. We noted in last week’s report that dovish economic projections and
rhetoric from the FOMC had caused short-term bonds to rally and the dollar to sell
off. It also pushed the market-implied liftoff date back to October. Even more
strikingly, as of Friday, the implied chance of liftoff by the end of 2015 has shrunk
to only 63%. What is the other 37% thinking? And what state of the world would
actually cause the Fed not to hike this year? In spite of these market reactions, we
maintain our view that delaying liftoff to 2016 is highly unlikely. Quite simply, two
factors drive U.S. monetary policy: (1) how the economy behaves and (2) what the
FOMC thinks is appropriate in a given scenario—its reaction function. Both factors
point to a hike this year.
The U.S. economy has begun the year on a disappointing note, which has not
surprisingly led to downgrades in FOMC projections for growth and inflation. But as
Dennis Lockhart clarified, “lower economic forecasts … reflect mostly ‘transient’
issues that [do not] fundamentally change its outlook.” More importantly, the
threshold for a substantial revision to the FOMC’s communication of a mid-year
liftoff has not been met. For one, disappointing growth in economic activity has
been balanced by a long string of upside surprises from a strong labor market. In
September 2012—the first time the FOMC published economic projections for
2015—unemployment (as of August) stood at 8.0% and the Fed’s central tendency
for 2015 was 6.0% to 6.8%; as of today, unemployment stands at 5.5%, and the
year-end expectation has declined to 5.0% to 5.2%.
Another consideration is that the Fed’s Summary of Economic Projections
represents the distribution of individuals’ forecasts of the most likely outcome,
which is not the same as a probability distribution. That these projections are
modes rather than means further reflects that they do not depict the upside or
downside risks to participants’ core views. We note, however, that the Committee
was at pains to maintain its characterization of risks to the GDP and labor market
outlooks as “balanced.” Approaching liftoff also means narrowing the range of
plausible economic outcomes and projections, and reducing opportunities to
change the Fed’s economics expectations. There is some risk that recent stalls in
business sentiment and capital spending are passed along to hiring. So far, where
real activity has softened, labor markets have remained surprisingly resilient. But
what would the labor market have to look like to knock the FOMC off course for
2015? It would not be pretty. A standard monetary policy rule like Taylor (1999)
suggests that erasing the 50bps of tightening in the “dots” would require the
unemployment rate—which declined 1.2% over the past year—to essentially stall
near current levels, an outcome that we view as implausible.
The other factor that could drive a rate path revision is evolution of the Fed’s
reaction function. However, that function tends to evolve slowly. New members
Chart of the Week
Converging on 2015
Since January 2012, the Fed has been Distribution of FOMC participants’ views on “appropriate timing of policy firming”, %
publishing participants’ views on the 100
2016
“appropriate timing of policy firming.” As
80
the date of liftoff nears, a consensus has
developed and grown around 2015.
60
According to the March meeting’s
2014
2015
projections, 15 out of 17 members still 40
believe 2015 is the most appropriate date
2013
for fed funds “liftoff,” and at least one of the 20
two dissenters is most likely a non-voter.
2012
Similarly, only two of the “dots” suggest no
0
hikes in 2015, and the bulk of dots suggest
Jan Apr Jun Sep Dec Mar Jun Sep Dec Mar Jun Sep Dec Mar
2012 2012 2012 2012 2012 2013 2013 2013 2013 2014 2014 2014 2014 2015
two or three.
Sources: Federal Reserve, GIM Solutions-GMAG.
Data up to March 18, 2015.
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FOR INSTITUTIONAL/WHOLESALE OR PROFESSIONAL CLIENT USE ONLY | NOT FOR RETAIL DISTRIBUTION
GIM Solutions-GMAG
Weekly Strategy Report
Miscellaneous Musings
According to Baker Hughes, the
number of active U.S. oil drilling rigs
has fallen by nearly 50% from its
peak last September. Despite this,
the
U.S.
Energy
Information
Administration reports U.S. shale oil
production in April up by 13% over
the same timeframe and unchanged
compared to March. Meanwhile,
since its peak in June of last year
Bloomberg’s Bakken crude oil spot
price has fallen by 56%, although it
has stayed in a relatively stable
trading range between USD 38 and
USD 49 since the start of this year.
Since mid-2014, U.S. consumer
confidence has tracked the price of
oil and gasoline, rising as energy
prices fell. When gasoline prices
started rising from a bottom in
January, confidence immediately fell.
But in the past two weeks,
Bloomberg’s measure of consumer
comfort has un-linked from gas
prices and continued upward—an
encouraging sign for U.S. domestic
consumption in Q2.
As the People’s Bank of China
(PBoC) looks increasingly likely to
loosen monetary policy again in
response to a spate of disappointing
economic data, the Shanghai Stock
Exchange A Share Index is up 11.5%
month-to-date, presumably driven by
Chinese retail money with few other
places to go. On the other hand, the
Hang Seng China Enterprises Index,
which may more closely reflect the
economic realities in China, is
actually in the red this month.
gradually replace old, leadership rotates, and consensus on the Committee is
characterized by a high degree of inertia. This inertia implies a high bar for a
sudden change of heart (and no noteworthy changes to FOMC voters are expected
this year). We see merit in arguments that the Committee is putting increasing
weight on the inflation part of its mandate, which would push tightening back given
the lack of meaningful wage and price pressures. But that concern seems more
than offset by the Committee’s desire to normalize policy, maintain flexibility,
escape the zero lower bound, and do so when long-term Treasury yields are likely
to remain subdued as the policy rate rises—that is, sooner rather than later.
As we now approach an end to seven years of zero interest rate policy (ZIRP), a
number of mainstream economists outside the Fed have called for the central bank
to wait for clear signs that inflation is picking up before raising rates. One argument
for post-2015 liftoff centers on the idea of “secular stagnation.” Tightening amidst a
slow expansion after a financial crisis and deleveraging cycle also presents its
unique unknowns, not to mention the asymmetric risks to monetary policy around
the zero lower bound. History may ultimately judge the correct path of tightening,
but the truth here is moot insofar as the Fed’s current reaction function is
concerned. The Committee’s views on these concerns are decidedly mixed, and
the political economy of consensus building will ultimately balance cautious voices
like Bill Dudley with those of Stanley Fischer who has steadfastly supported rate
hikes this year. On balance, though, the Fed is quite literally done with being
patient. Allowing those calling for a delayed hike to affect one’s judgment of when
the Fed will raise rates—as we believe the market has—is to confuse two distinct
questions: how should the Fed act, and how will it act?
Our central scenario is for the Fed to hike in September, and we believe that hiking
in 2015 is much more likely than what the market has priced in. From here, the
pace of Fed tightening ultimately matters more to our directional bets than the liftoff
date. For much the same reasons as with the liftoff date, we see a steeper
probability-weighted path than the market sees—one closer to the core FOMC
view. Therefore, we continue to expect a flattening of the U.S. yield curve as
international demand for Treasuries keeps long-end yields subdued.
A farewell to forward guidance. As U.S. monetary policy normalizes, rate
volatility is likely to increase from the lows of zero interest rate policy and the
erstwhile quantitative easing environment. Already this year, the Merrill Lynch
Option Volatility Estimate (MOVE) Index for 1-month Treasury options has reached
highs not seen since the “taper tantrums” of 2013. Occasional patches of rate
volatility are more likely with the transition away from heavy forward guidance
implying greater rate uncertainty, especially with the Fed no longer actively leaning
on the yield curve. Looking at historical Fed rate hiking cycles, today’s environment
looks less like the “1994 moment” and more like 2004’s “bond conundrum,” in
which the Fed clearly communicated its intention to hike rates in advance and a
global savings glut helped keep the long end of the Treasury curve remarkably
stable. Unlike 2004, however, the Fed’s intentions are not yet priced by markets;
as the Fed actually begins raising rates, the “dots” and futures will need to
converge and this could be a bumpy ride.
Michael Albrecht
All data sourced from JPMAM, Bloomberg, and Datastream, unless stated otherwise.
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