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Fixed-Income Insights

The U.S. Federal Reserve’s inclusion of the health of overseas markets and economies as a policy consideration could slow the pace of U.S. rate hikes.

 

In Brief

  • The U.S. Federal Reserve’s (Fed) March policy statement seemingly added the health of global economies and markets to its traditional dual mandate of full employment and 2% inflation.
  • This likely was reflected in the Fed’s projection of a slower pace of rate hikes in 2016.
  • The upshot is that U.S. rate normalization appears to have taken a backseat to global stability and economic improvement. 
  • The key takeaway— A more global perspective by the Fed seems capable of slowing U.S. rate normalization, supporting risk assets, and promoting conditions for global growth.  However, low rates and aggressive monetary policy have limits to their growth-promoting capabilities.

 

The most important takeaway from the meeting of the Federal Open Market Committee (FOMC), the policy-setting arm of the U.S. Federal Reserve (Fed), on March 15–16, was not the unexpected shift in the number of projected rate hikes in 2016 from four to two. The most striking thing that emerged from the meeting was the possible reason for the shift itself.  The Fed’s dovish policy tilt seemed driven not by a focus on its two stated mandates—full employment and 2% inflation—but by a new emphasis on “global economic and financial developments” (what we’ll call GEFD). Such a change carries important policy and investment implications.  Along with recent moves by the European Central Bank (ECB), the shift in Fed policy contributes to an environment supportive of risk assets.    

If the Fed still claims to be “data dependent,” then it just introduced new data.  Rather than the regular monthly and quarterly U.S. statistical reports that are the staples of the Fed’s policy diet, the new inputs will be market, policy, and geopolitical developments outside the United States.  While GEFD is described as a risk rather than a policy objective, it has factored significantly in the FOMC’s expectations for future rate hikes and, essentially, has offset the recent movement toward the Fed’s employment and inflation objectives.  On the labor front, that progress included the economy’s achievement of a 4.9% unemployment rate, continued strong jobs growth, and an ongoing improvement in wage gains, according to data from the Bureau of Labor Statistics. As for inflation, data from the Bureau of Economic Analysis show that the core personal consumption expenditures index (the Fed’s favored inflation measure) rose, to 1.7% year over year (2.0% on an annualized basis), over the three months ended January 2016 (the most recent data available). 

This visible progress toward the Fed’s dual mandate did not even elicit a reminder in the March FOMC statement that rate normalization was important or that every meeting should be considered “live” with potential for a rate hike.  Lack of such discourse is surprising, given the minutes from earlier FOMC meetings that revealed policymakers’ expectations that inflation would rise over the medium term, to 2%, was sufficient to pursue rate normalization. 

New Objective
Instead, the Fed chose to ignore the data that were to drive its policy in favor of a new consideration: the health of markets and economies overseas.  Such a shift implies a new, more cosmopolitan perspective by the Fed, adjusting its policy focus to factor in GEFD—and help support global growth.  In other words, U.S. rate normalization appears to have taken a backseat to global stability and economic improvement. 

If this perspective of global interdependence prevails at the Fed, the conduct of monetary policy among the world’s major central banks has just become more coordinated.  This carries important investment implications.  For starters, risk assets could benefit, as a cooperative focus on growth creates an environment broadly supportive of risk assets globally.  A Fed conscious of global economic and financial developments seems less likely to draw capital from elsewhere in the world through aggressive rate hikes (higher U.S. yields have attracted investments from other nations where yields on government debt have turned negative) while economic fragility prevails elsewhere.  As a result of this perspective, we believe select emerging markets may have better prospects for improvement than was believed earlier this year. 

In terms of domestic assets, dollar stability, fostered by the Fed’s greater emphasis on GEFD and promoted by a slower pace of rates, reduces uncertainty as well as profit pressures on U.S. multinationals.  Both developments could support U.S. corporate earnings as well as company valuations. 

Policy Limits
Slower rate hikes also allow longer time for compounding of higher yields of issuers of lower-quality U.S. fixed-income securities, while the focus on promoting conditions of economic growth underpins the earnings potential and credit strength of such companies.  High-yield securities and the lower tiers of investment-grade debt may offer interesting opportunities, especially at yield spreads that are wider than historical norms.  At the same time, other central banks, particularly the ECB, spur interest by non-U.S. investors in higher-yielding U.S. government and corporate debt via policies designed to keep euro interest rates relatively low, if not negative.     

A more global perspective by the Fed seems capable of slowing U.S. rate normalization, supporting risk assets, and promoting conditions for global growth.  However, low rates and aggressive monetary policy have limits to their growth-promoting capabilities.  Stability of oil prices, thoughtful approaches toward mitigating China’s slowing growth, and fiscal policies in developed countries that promote structural reforms, business investment, and tax reform are needed to reduce uncertainty and create incentives that can be catalysts to growth.

Collectively, such conditions, especially when combined with easy monetary policy, could produce continued economic growth both in the United States and globally.  Without them, easy monetary policy may witness the limit of its effectiveness, tempering its potential impact on investments in the process.

 

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