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Fixed-Income Insights

Here’s a look at economic and policy considerations that might influence the U.S. Federal Reserve’s longer-term policy path. 

 

In Brief

  • Although the U.S. Federal Reserve (Fed) is widely expected to hike the fed funds rate at its policy meeting on June 13–14, investors are questioning Fed projections for one additional tightening in 2017.
  • Indeed, in the wake of disappointing U.S. employment report on June 2, fed funds futures imply less than a 25% probability of a rate hike at the Fed meeting in September.
  • Investors may wish to focus on prospects for additional rate hikes by the Fed in 2018, along with the factors that may influence the central bank’s decisions. We have identified four to watch:

             –The likelihood of above-average U.S. gross domestic product growth

             –Fed expectations for inflation

             –The effects of a tightening U.S. labor market

             –The Fed’s view of its progress in normalizing interest rates

  • The key takeaway:  Potential changes in Fed policy expectations carry important implications for fixed-income investments, particularly over the next 18 months.

 

Lower-than-expected U.S. jobs growth in May, following recent declines in inflation measures and a disappointing report on first-quarter gross domestic product (GDP), has changed expectations for the path of U.S. Federal Reserve (Fed) policy. Although an increase in the fed funds target rate to a range of 1.0–1.25% is still expected at the Fed’s policy meeting on June 13–14, one closely watched market indicator—fed funds futures—suggests that a subsequent move in 2017 is no longer widely anticipated. Such that, according to Bloomberg (especially in the wake of the June 2nd release of the May employment report), there is a probability of less than 25% that there will be a rate hike decided on at the September Fed meeting.

A more important topic for investors to consider might be Fed expectations for 2018. Although the Fed's March “dot plot” projections indicate a total of three rate hikes in 2018, fed funds futures suggest investors now expect only one. U.S. Treasury yields mirror investor expectations. After reaching 1.39% in March 2017, the yield on the two-year Treasury note closed at 1.29% on June 2. The 10-year Treasury yield fell, from 2.60% to 2.16%, over the same period, according to Bloomberg.

Whether the Fed fulfills its March 2017 rate-hike projections, or finds itself conforming to investors’ scaled-back expectations, has important implications for fixed-income investments, particularly over the next 18 months. Here, we’ll examine four key factors that could inform the Fed’s policy trajectory in the months to come.

GDP
The Fed may be less concerned about weak first-quarter GDP than investors, thanks to a pattern that has emerged over the past several years: weak first-quarter numbers have been normalized by growth in subsequent quarters.  Preliminary indications suggest 2017 may continue to follow that pattern. Recent readings from the Atlanta Federal Reserve Bank's GDP tracker suggest 4.1% growth for the second quarter. If that number is realized, growth for the first half of 2017 would average 2.6%, better than the 2.1% annual average since the financial crisis of 2008–09. Annual GDP of 2.0% or more offers no rationale for the Fed to change its plans to normalize interest rates. Continued jobs growth, wage gains, and robust consumer confidence, supported by improving housing prices, rising equity valuations, and respectable savings rates, suggests strong consumption is positioned to continue to drive U.S. economic growth.

Inflation
The Fed's preferred measure of inflation, the Personal Consumption Expenditures (PCE) Index, recently fell, from 1.9% in March to 1.7% in April, while the core PCE (which excludes food and energy prices) dropped, from 1.6% to 1.5%, according to U.S. Department of Commerce. While such low levels, relative to the Fed's 2% inflation target, offer latitude for the Fed to delay rate hikes, commentary in recent speeches by Fed officials suggests that there is no intention to modify the central bank’s pace of interest-rate normalization. In fact, Boston U.S. Federal Reserve Bank president Eric Rosengren suggested, in a speech on May 10, that four rate hikes in total may be appropriate for 2017.  San Francisco Fed president John Williams also said, in a speech on May 29, that investors should not rule out more than three increases total for this year. Williams went on to suggest that although inflation was lower than the Fed's target, he expected that 2% target to be reached by next year.

Jobs
The disappointing U.S. jobs report in May also seems likely to influence Fed policy less than investors may expect. Although the nonfarm payrolls (NFP) increase of 138,000 in May was weaker than expected, after a monthly gain of 253,000 in a private employment survey issued by payroll services provider ADP on June 1, the monthly NFP average of 162,000 is still respectable, with unemployment at only 4.3%. If a slowdown in reported job growth is a function of fewer qualified workers, wage inflation, which is of greater concern to the Fed than the number of jobs, could increase as employers seek to attract and retain effective workers by raising compensation.

The Fed Perspective
Finally, the Fed's underlying agenda of rate normalization is an important factor, because it influences rate-hike behavior. Studies by both the St. Louis and San Francisco Federal Reserve banks concluded that quantitative easing did little or nothing to stimulate economic growth, leaving reductions in the fed funds rate as the central bank’s primary policy tool for stimulus. If short-term rates are not back up toward normal levels when the next economic downturn unfolds, the Fed may find itself ill-equipped to prime the economic pump. Thus, its longer-term perspective about economic growth, bolstering employment levels, and wage inflation may be consistent with a gradual and patient approach to higher rates, even if a pause could be justified, particularly with the prospect of some fiscal policy stimulus and improving growth elsewhere in the world.

Investors will get a better idea of how recent data releases have influenced the Fed's 2018 perspective after the June meeting of the Federal Open Market Committee (the Fed’s policy-setting arm). New dot-plot projections will be available at that time, as well as updates on longer-term expectations for economic growth and inflation. Of particular importance to investors will be any change in the Fed's rate-hike projections for 2018, especially in light of some reduction in its balance sheet by that time. Expect interest rates to respond accordingly.

 

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