FOR INSTITUTIONAL/WHOLESALE OR PROFESSIONAL CLIENT USE ONLY | NOT FOR RETAIL DISTRIBUTION 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. 1 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. NOT FOR RETAIL DISTRIBUTION: This communication has been prepared exclusively for Institutional/Wholesale Investors as well as Professional Clients as defined by local laws and regulation. The opinions, estimates, forecasts, and statements of financial markets expressed are those held by J.P. Morgan Asset Management at the time of going to print and are subject to change. Reliance upon information in this material is at the sole discretion of the recipient. Any research in this document has been obtained and may have been acted upon by J.P. Morgan Asset Management for its own purpose. References to specific securities, asset classes and financial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as advice or a recommendation relating to the buying or selling of investments. Furthermore, this material does not contain sufficient information to support an investment decision and the recipient should ensure that all relevant information is obtained before making any investment. Forecasts contained herein are for illustrative purposes, may be based upon proprietary research and are developed through analysis of historical public data. J.P. Morgan Asset Management is the brand for the asset management business of JPMorgan Chase & Co. and its affiliates worldwide. 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