July Quick Read on the US Economy

The economic news improved somewhat from my last update.  The labor market looks more solid than it did a month ago and there are some signs the manufacturing sector may have found it footing.  I believe the Brexit vote will likely have only a modest direct impact on the US, but will make all observers less confident of their predictions for global growth.  This summer, the fed may try to convince the market that it will hike again in September, but my guess is that the December will be the earliest.

 

Our latest reading for the Astor Economic Index® (“AEI”) is higher than last month, and at near the highest level posted this year.  I still see the US as currently growing above average. The AEI is a proprietary index that evaluates selected employment and output trends in an effort to gauge the current pace of US economic growth.

Source: Astor calculations

The labor market has been doing its noisy best to upset the stomachs of economists.  June’s payroll number showed a solid recovery from the weak numbers posted for April and May.  That being said, smoothing the series somewhat by looking at year over year percentage change shows that the US economy is still adding jobs but at a somewhat slower pace than has prevailed over the last few years.

The nowcasts produced by the Federal Reserve banks of Atlanta and New York are both still showing stronger growth in the second quarter than the first.  The Atlanta Fed is currently estimating 2.3 SAAR and the New York Fed 2.1.  These are both slightly weaker than last month’s estimate.  Both have been updated since the employment report.

 

The biggest economic surprise of the year has been the vote for the UK to leave the European Union.  At Astor, we were pleased to provide rapid reaction to this event on our blog on the morning and afternoon of the vote.  I think our analysis holds up well: see CEO Rob Stein’s take here and mine here.   As some of the dust has settled, short term implications for the UK economy are seen as dramatic by many economists.  For example, the panel of economists surveyed by Consensus Economics is now forecasting 1.1% growth in 2017, down from a 2.1% forecast last month.  Reductions for growth in the Eurozone are smaller.  Consensus Economics now forecasts 1.4% in 2017 down from 1.6%.  These same economists are not currently seeing significant direct effects on the US or the rest of the world.  The swift resolution of the UK leadership contest (with a new Prime Minister this week as opposed to the September time table originally announced) may offer grounds for optimism that a deal may cut short the period of uncertainty.

 

I see Brexit uncertainly leading to reduced investment by both firms and households as the primary channel affecting UK GDP.  To the to the extent that the uncertainly will have sustained spillovers into the financial markets it could have indirect effects on the US.  For example, the dollar initially rallied after the vote, but is now about the level that obtained in early June.  Should the dollar appreciate against our trading partners, it would be expected to make exporting more difficult.  In my opinion, the largest effect, however, seems to be in government bond yields.  US ten year yields have moved down 25 basis points to a yield of around 1.50% as this note is being written.  While, some of this may be safe haven demand that one can hope will be reversed as a path forward emerges, there are few of the other typical signs of investor fear.  Investors willing to take 1.5% for 10 years may be foreseeing long spell of a worrying lack of attractive opportunities for investment in the US and abroad.

 

When last we heard from the fed, their rate-raising plans were put on hold by the poor payroll numbers in April and May.  Does the decent report for June portend another hiking scare?  I think it is too soon to tell.  My interpretation of their speeches is that for the fed to raise rates they need to be convinced that the labor market is at full employment and that inflation will return to target in the medium term.  The last report has some points for both sides.  If the decision was finely balanced before, then in my opinion the Brexit vote strengthened the doves’ position.  Neither inflation nor the labor market are likely to see a boost because of it, and I imagine the decline in yields has the fed’s attention.  My guess is that a few hawks will try to make the case for a hike over the summer but that the fed will not hike before December.  For what it’s worth, the most common interpretation of rates implied by fed fund futures market sees only a small chance of a hike before the end of the year, as opposed to the situation in January when more than one additional hike was priced in.  A sustained return to the relatively robust labor market we saw over 2014-2015 would increase the likelihood of a hike.

 

Overall, I am relieved the labor market seems to have bounced back from a weak April and May, but I will feel better about the economy if we see this strength confirmed over the next few months.

 

 

All information contained herein is for informational purposes only. This is not a solicitation to offer investment advice or services in any state where to do so would be unlawful. Analysis and research are provided for informational purposes only, not for trading or investing purposes. All opinions expressed are as of the date of publication and subject to change. Astor and its affiliates are not liable for the accuracy, usefulness or availability of any such information or liable for any trading or investing based on such information.

 

“The Astor Economic Index® is a proprietary index created by Astor Investment Management LLC. It represents an aggregation of various economic data points: including output and employment indicators. The Astor Economic Index® is designed to track the varying levels of growth within the U.S. economy by analyzing current trends against historical data. The Astor Economic Index® is not an investable product. When investing, there are multiple factors to consider. The Astor Economic Index® should not be used as the sole determining factor for your investment decisions. The Index is based on retroactive data points and may be subject to hindsight bias. There is no guarantee the Index will produce the same results in the future. The Astor Economic Index® is a tool created and used by Astor. All conclusions are those of Astor and are subject to change.”

306161-443

April Quick Read on the US Economy

The latest numbers on the US economy were positive. As a promising sign for the future, the global manufacturing environment may be showing signs of stabilizing – coincident with a stabilizing of commodity and international equities prices. I still believe the Fed will continue to hold and will not raise rates in April.

Our Astor Economic Index® (“AEI”) shows growth somewhat above the recent average and stronger than last month. The AEI is a proprietary index that evaluates selected employment and output trends in an effort to gauge the current pace of US economic growth.

Source: Astor calculations

Source: Astor calculations

The employment report (nonfarm payrolls) for March was broadly positive. The number of new jobs was again quite close to its two-year average. We can see no sign of broad based weakness in the economy within the payroll numbers. The tick up in the unemployment number was welcome as it represents more people looking for work who were previously on the sidelines of the labor market. The prime age employment-population ratio has improved markedly in the last quarter, though it is still lower than the previous expansion.

Despite this good news on the employment front, the preliminary release for GDP for the first quarter of 2016 – due at the end of April – is likely to be weak. The chart below shows the Atlanta Fed’s current estimate of first quarter GDP calculated via their GDP Now methodology. The weakness – if it materializes in the final numbers – can partially be put down to a higher trade deficit and an inventory drawdown both of which can be transitory. Weaker consumer expenditures is more concerning.
It is also worth noting the BEA is considering a secondary seasonal adjustment to try and account for the pattern of unusually weak first quarters which economic observers have been subjected to over the last few years.

The Atlanta Fed's GDP Now

The Atlanta Fed’s GDP Now

For several months we have been highlighting the weak international manufacturing environment. This weakness is most easily seen in the chart below of global manufacturing purchasing managers indexes. which have shown sharp deterioration over the last year. The latest numbers show a bit of an improvement so perhaps we can be hopeful, though careful readers will recall similar optimism in February’s read. If this bounce continues, it is possible that some of the external weakness in the US will begin to be reversed.

Source: Markit, NAPM, Bloomberg, Astor Calculations

Source: Markit, NAPM, Bloomberg, Astor Calculations

The Federal Reserve chose not to raise rates in March and statements since lead me to believe the hawks on the committee have become somewhat convinced the prospect of a weaker economy poses a greater danger than the specter of run-away inflation. The official stance is the FOMC wants to be convinced inflation is heading back to its target – somewhat above current levels. I would expect the reversal of recent trends in the dollar and crude oil prices will both tend to move inflation higher in coming months. The latest data we have shows the Fed still sees an additional two to three hikes in 2016, while the market predicts about one.

In short: The evidence today suggests to me the US continues another month of positive if somewhat tepid growth.

All information contained herein is for informational purposes only. This is not a solicitation to offer investment advice or services in any state where to do so would be unlawful. Analysis and research are provided for informational purposes only, not for trading or investing purposes. All opinions expressed are as of the date of publication and subject to change. Astor and its affiliates are not liable for the accuracy, usefulness or availability of any such information or liable for any trading or investing based on such information. The investment return and principal value of an investment will fluctuate and an investor’s equity, when liquidated, may be worth more or less than the original cost.
The Astor Economic Index® is a proprietary index created by Astor Investment Management LLC. It represents an aggregation of various economic data points: including output and employment indicators. The Astor Economic Index® is designed to track the varying levels of growth within the U.S. economy by analyzing current trends against historical data. The Astor Economic Index® is not an investable product. When investing, there are multiple factors to consider. The Astor Economic Index® should not be used as the sole determining factor for your investment decisions. The Index is based on retroactive data points and may be subject to hindsight bias. There is no guarantee the Index will produce the same results in the future. The Astor Economic Index® is a tool created and used by Astor. All conclusions are those of Astor and are subject to change.

304161-388

January Quick Read on the US Economy

The US continues to post moderate growth, though pockets of weaknesses remain.  Global financial markets started the year trying to read the magic eight ball of the Chinese equity and currency markets – a recipe for emotional distress.  Overall, my judgement about the current expansion remains unchanged with slightly above-average growth.

The US economy

·         Our Astor Economic Index® (“AEI”) shows growth somewhat above the ten-year average and slightly better than last month.  The AEI is a proprietary index that evaluates selected employment and output trends in an effort to gauge the current pace of US economic growth.

Source: Astor calculations

Source: Astor calculations

·         The most important and timely indicators for December 2015 were mixed.  On the positive side, payrolls were quite strong and above expectations.  The only quibble with last Friday’s report being recent signs of wage growth seem to have stalled.  I believe a sustained period of real wage gains will be necessary for a robust consumer sector and hence a strong economy.

·         On the bad news side, the weakness in the manufacturing sector as measured by the ISM Purchasing Managers Index continued.  Industrial production, as measured by the year-over-year change in the Fed’s industrial production index, turned negative for first time since the recession in last month’s release.  I tentatively started calling a manufacturing recession last month and I feel a bit stronger about that now.  The non-manufacturing PMI is still fairly strong and though it is off its recent highs, it is still about the average level in the current recovery.

Source: Federal Reserve, Astor calculations

Source: Federal Reserve, Astor calculations

·         While I still see the current (that is, for early 2016) state of growth  as above average, it is looking like the fourth quarter will see a weak GDP print.  The Atlanta Fed’s GDP Now project is currently forecasting growth below 1% (quarterly SAAR).

The Fed

·         The Fed finally began to raise rates with its December meeting.  2016’s market volatility, on its own, is unlikely to cause the Fed to reconsider its path unless it gets more extreme.  It is said central banks tighten according to plan and ease in reaction to events.  The consensus seems to be that the Fed’s plan is to tighten a quarter point at every other meeting or so for a while, as long as the economy continues to hold its present course.  Weak inflation prints, however, could give the FOMC pause.  With energy prices moving lower again this year it is hard to see early inflation prints being strong.  See Tim Duy’s dissection of the December minutes for more.

·         If the Fed does stay the course, the next big obsession for Fed watchers will be when they will begin to allow their QE investments to roll off.  The Fed currently reinvests coupon and principal payments on its portfolio in similar securities so as to maintain a level portfolio.  The first step to reducing the balance sheet will be to cease this reinvestment.  (For a dated but still, I think, correct description see my Cleaning Up After The Party Is Over).  Expect fevered commentary about the issue this summer if nothing else spices up the dreary lives of central bank observers.

The international environment

·         My reading of the global picture has not changed.  The fundamental fact of the global economy today is the weakness in China and the attendant disruption in the supply chains built up to feed its growth.  I believe we see this result in the broader commodity weakness as well as the manufacturing weakness discussed above.

·         There is a great deal written on the Chinese economy, not all of which increases understanding.  A few pieces I appreciated:

o    Noah Smith on why we might not have to fear the Chinese stock market

o    Martin Sandbu on what we should be afraid of (Chinese capital flows)

o    Paul Krugman on when China stumbles.

·         Note too that the US is not alone, the UK’s industrial production also recently turned negative year-over-year.  Globally, the GDP-weighted manufacturing sector PMI has been declining steadily for the last 18 months, though it is still above the lows seen in this measure in 2012.  Note too that those low levels were associated with a stagnation, not a decline, in the level of global industrial production.

Sources: Bloomberg, Markit, IMF, Astor calculations

Sources: Bloomberg, Markit, IMF, Astor calculations

·         In addition to the diffuse reduction in commodity demand, there is an energy specific supply shock.  One can imagine this an oily game of chicken among suppliers waiting to see who will take remove supply from the market first.

Conclusions

Overall, I see the US as currently in modest growth and perhaps we should be pleased the Economy has done as well as it has in a challenging external environment.

 

All information contained herein is for informational purposes only. This is not a solicitation to offer investment advice or services in any state where to do so would be unlawful. Analysis and research are provided for informational purposes only, not for trading or investing purposes. All opinions expressed are as of the date of publication and subject to change. Astor and its affiliates are not liable for the accuracy, usefulness or availability of any such information or liable for any trading or investing based on such information. The investment return and principal value of an investment will fluctuate and an investor’s equity, when liquidated, may be worth more or less than the original cost. 

 301161-350

 

How the Fed Sees Inflation

The Fed sees inflation a bit differently than many in the markets do.  In this note I will discuss some of the folk-economics that get talked about casually on the trading floor. I will contrast that with how Janet Yellen has recently described her view of US inflation dynamics (mainly as expressed in her very interesting speech Inflation Dynamics and Monetary Policy).

If you feel like you have a good handle on how inflation works, maybe you should think again.  Macroeconomists in general would not describe inflation as a well-understood problem.  Economist Noah Smith, for example, says baldly that “macroeconomists don’t yet understand how inflation works.”  Despite that chastening counsel, many of us have simple models of inflation that we use.

For example, perhaps inflation is caused by commodity prices.  Roughly, copper gets expensive so wire gets expensive so electronics get expensive so everything gets expensive.  Those of us with memories of the 1970s and the high oil prices are particularly susceptible to this.  And to be sure, in the 1970s inflation and commodity prices did increase together and some economists have found a statistical relationship in that blighted decade.  In the more recent period, however a rise in energy prices in one year will not forecast a rise in inflation in the following year (see this paper by Kansas City Fed economists Todd Clark And Stephen Terry, for example).

Since 1980, however, it is tougher to find a consistent pass-through from commodity prices to broader inflation.  What we actually tend to see is prices of commodities tend to fluctuate widely, and hence CPI tends to move more than core CPI.  But the equation seems to be that the ex-food and energy CPI tends to be more stable than CPI including commodity prices.

Source: Bloomberg

Source: Bloomberg

To be clear, of course if gas prices go up 10% today that will have an impact on today’s inflation.  What is not so obvious before careful investigation is that it will have little direct impact on tomorrows inflation.

Do rising wages forecast changes to inflation?  Like commodity prices, this is an intuitive idea without empirical support in the United States since the 1980s.  A summary of the state of research can be found in The Passthrough of Labor Costs to Price Inflation Peneva and Rudd.  This research undermines the idea of a wage-cost spiral operating recently in the US, and instead suggests the preferred interpretation is high wages are an indicator of a tight labor market.

What does cause inflation?  The prices of inputs to production, especially imports, matter for inflation as does the level of resource utilization.  But, again, this is only for the current level of inflation.  What can we use to forecast tomorrow’s level of inflation?  For the longer trend around which prices fluctuate, however, economists have settled mainly on the idea that one of the most important determinants of inflation is inflation expectations themselves, or more precisely, the difference between realized and expected inflation.  This is called the expectations augmented Philips curve.

In some sense, regressing from inflation to expected inflation does not sound like it solves much. What causes inflation expectations in their turn?  The expectation of inflation expectations?   Nevertheless, this seems to be the best that economist have for the time being.  People make plans and contracts based on some sort of expectation of inflation and when the world does not meet their forecast the adapt in some way.

The great thing about stable inflation expectations is that once you have gotten the expectations to a level you are comfortable with then prices should revert to target as people assume that moves away from the target will be reversed.  The bad news is if expectations are stuck away from the desired level, small deflations tend to move back to the bad level too.  The Fed feels it has built up some credibility by moving expectations to around 2%, the target which was implicit for the second half of the Greenspan years and which because explicit under Bernanke.  I believe a large part of the motivation for the balance sheet expansion (QE) was to take insurance against inflation expectations becoming anchored significantly below 2%.

An important question is whether inflation expectations are indeed well anchored.  Presumably, businesses and consumers extract some sort of trend rate of inflation when making expectations.  A long period of actual inflation away from the target will likely eventually shift inflation expectations.  However, no one knows the parameters of such a function.  The Fed has undershot its 2% target much more than it has overshot it, and its extreme actions to move inflation back to target in the last few years have not been successful to date.  The Fed believes that is because of temporary factors which should wash out over time.  We shall see.  The reality is that actual inflation expectations, however measured, have come down dramatically since the crisis and have not recovered.

Overall, then, the Fed thinks it can solve its inflation mandate by reacting with studied earnestness to sustained tightness in resource utilization because this could lead to the extended bouts of inflation that could shift inflation expectations away from the target.  At the same time they can look though inflation caused by temporary changes in market prices of currencies or commodities, as these do not forecast future levels of inflation.

How does this play into the Fed’s current decision and likely course of hikes?  Here is my interpretation based on closely following what FOMC members are saying: The Fed is raising rates a small amount now so it does not have to raise them a large amount later.  This calculus is all based on keeping inflation expectations well anchored.  The Fed feels resource utilization is tight enough that it needs to ensure the economy does not experience a protracted bout of high inflation.  To that end, it seems to slow growth slightly.  The alternative, in the Fed’s view, is in the medium term there will be a long period of above target inflation which will take a substantial slowdown in the economy to contain.

Source: Bloomberg

Source: Bloomberg

I think it is possible to disagree with this logic. I would likely vote against a hike if I was on the board, but it does make sense.  Given the tepid realized inflation figures over the last fifteen years, it also suggests to me that the Fed will not raise rates much.  My guess is 25 basis points every other meeting for the next year, leaving fed funds at about 1% a year from now.  Note that at that level, real rates would still be negative, and thus the Fed will still be “easing”, though at a reduced level.  I expect Low and Slow to be the watchwords for the Fed in 2016.

[Edited 2015-12-17 to add various links accidentally dropped]

All information contained herein is for informational purposes only. This is not a solicitation to offer investment advice or services in any state where to do so would be unlawful. Analysis and research are provided for informational purposes only, not for trading or investing purposes. All opinions expressed are as of the date of publication and subject to change. Astor and its affiliates are not liable for the accuracy, usefulness or availability of any such information or liable for any trading or investing based on such information. The investment return and principal value of an investment will fluctuate and an investor’s equity, when liquidated, may be worth more or less than the original cost. 

December Economic Read

The US economy continues its pace of modest expansion. Though self-sustaining growth continues to be the most likely outcome, a few soft spots – mainly related to weak growth overseas – continue to worry. I expect the economy to adapt well to the beginning of a shallow and gradual rate hike cycle.

Our Astor Economic Index® shows growth somewhat above the ten year average, though it is lower than a month ago. The AEI is a proprietary index which evaluates selected employment and output trends to try and gauge the current pace of US economic growth.

Good news first. The broad economy continues to expand as can be seen in the steady pace of jobs growth. It may be a promising sign for the future that construction jobs continue to grow at a slightly faster rate than they have since the Great Recession. The housing sector has been weak in the recovery and improvement would be welcome.

The weakness in the manufacturing sector continues as demonstrated by a range of indicators. The latest survey from the ISM was below the line demarcating manufacturing expansion/contraction, though this level is consistent with a growing economy, not a broad recession. This is also reflected in the index of industrial production. The manufacturing sub-index has been weak all year, though not nearly as weak as the mining sub-index.

Source: Bloomberg, Bureau of Labor Statistics, Institute of Supply Management

Source: Bloomberg, Bureau of Labor Statistics, Institute of Supply Management

I see this weakness mainly as a consequence of the slower pace of growth in the Chinese economy leading to broad emerging economy weakness which, in turn, is directly reducing prices on commodities produced in the US as well as reducing overseas demand for US produced intermediate goods. As part of the financial markets reaction to this adjustment the dollar has rallied about 20% against a broad currency index over the last 18 months. The IMF estimates that the dollar movement alone has reduced US GDP growth (by reducing net exports) by about 1% in the last few years.

Will this manufacturing recession spread to the rest of the economy? I do not believe recessions can be forecasted at significant horizons, so I will not lay odds. My guess, however, is that it would take significant further deterioration in the global environment for this to happen. And whatever odds you place on them, it is also possible that the headwinds the US is facing in the external environment will begin to dissipate or at least stop deteriorating next year, a slightly optimistic vision.

The continued decent growth in the US in the face of some overseas challenges is one of the reasons why the Federal Reserve will begin raising rates shortly. They seem to be anticipating the attenuation or reversal of growth constraining factors and hope that by starting rate hikes sooner they will not need to raise them as much. Additionally, if we take the Fed at their word, they are worried about labor market slack being close to completely used up.

If I were on the FOMC I would vote against a hike as the Fed’s inflation target does not seem to be close to binding any time soon and because I would be hoping to decrease the numbers of involuntary part timers as well as try to move the labor participation rate back higher, though demography limits potential gains.

Be that as it may, the Fed is still likely to initiate a rate hike, followed by a stately pace of follow-up rate hikes. Given that the Fed has not begun to shrink its balance sheet (maintaining a substantial stimulus) and that fed funds may only be around 1% a year from now, few serious observers are anticipating that this will seriously hurt the economy.

Overall, I am still cautiously optimistic on the US economy, though less so than last month and I will be watching developments in the export sector closely.


All information contained herein is for informational purposes only. This is not a solicitation to offer investment advice or services in any state where to do so would be unlawful. Analysis and research are provided for informational purposes only, not for trading or investing purposes. All opinions expressed are as of the date of publication and subject to change. Astor and its affiliates are not liable for the accuracy, usefulness or availability of any such information or liable for any trading or investing based on such information. The investment return and principal value of an investment will fluctuate and an investor’s equity, when liquidated, may be worth more or less than the original cost.

The Astor Economic Index® is a proprietary index created by Astor Investment Management LLC. It represents an aggregation of various economic data points: including output and employment indicators. The Astor Economic Index® is designed to track the varying levels of growth within the U.S. economy by analyzing current trends against historical data. The Astor Economic Index® is not an investable product. When investing, there are multiple factors to consider. The Astor Economic Index® should not be used as the sole determining factor for your investment decisions. The Index is based on retroactive data points and may be subject to hindsight bias. There is no guarantee the Index will produce the same results in the future. 312151-336

October Economic Read

• The most recent readings on the U.S. economy show a moderating pace of growth. Both points are worth emphasizing: the US is still growing but at a slower rate than a few months ago. We see support of this statement in the recent nonfarm payroll and ISM Manufacturing report releases. Even at the more subdued three-month average of 167,000 new jobs a month, we will still be net adding jobs above the number of new workers. Likewise, an ISM Manufacturing reading of 50.2 is below where we have been but still signals expansion (above 50). I believe the source of the slowdown is likely the sharp rise in the trade-weighted value of the dollar over the last several months and, to a lesser extent, weakness in the world economy.
• I see the weakness in the world economy as stemming mainly from the dislocation of global growth due to a lower level and a changing pattern of economic growth in China. It seems there is excess in the global supply structures that were built up to supply raw materials to facilitate the rapidly expanding Chinese infrastructure growth. Presently, it appears the Chinese government wants to shift growth to be more consumer oriented in addition to adapting to a more modest rate of economic growth.
• The chart below shows the year-over-year change in the volume of world trade as measured by the CPB. We can see world trade has been at somewhat lower levels since the global financial crisis and even bearing that fact in mind, the volume of world trade is at low though not crisis levels.

Source: CBP, NBER, Astor Calculations

Source: CBP, NBER, Astor Calculations

• This world trade number is quite thorough, but not as timely as one would like. The chart above is only updated through July. The next chart shows the GDP-weighed purchasing managers indexes of the 20 largest economies for the last few years. This measure looks to have been slowing over the last few months though it does not look like an emergency.

Source: Bloomberg, Markit, Astor calculations.

Source: Bloomberg, Markit, Astor calculations.

• The Federal Reserve refrained from tightening in September though they made a special point to say October 28 is a live meeting, that is saying one in which the FOMC may raise rates. We can be sure there will be a deluge of Halloween related headlines before the meeting. Should we be braced for something more serious? As far as the market is concerned, the FOMC may as well play cards this month as almost no one believes they will raise rates. This belief is because the committee said it is waiting for further labor market strength, but we will not get any additional labor market information before the meeting.
• The Fed is also looking for a conviction that inflation will be heading toward its 2% target in the medium term. How is that side of the Fed’s dual mandate going? The chart below shows three different five year ahead inflation forecasts: the blue and green lines are derived from market prices and the red line is from the Philadelphia Fed’s Survey of Professional Forecasters.

Source: Bloomberg, Federal Reserve Bank of Philadelphia

Source: Bloomberg, Federal Reserve Bank of Philadelphia

• The market based forecasts show marked deterioration this year while the survey has held steady the last few months, though somewhat lower than last year. Various Fed officials have said they are looking through the market measures of inflation somewhat, thinking they may be artificially depressed due to temporary factors. A policy maker with a strong bias toward hiking might be able to square that desire that with current inflation forecasts, but I think holding off would be more appropriate.
• Overall, this last month’s data has made us a bit more cautious on the economy, though we do see continued expansion in the U.S. as the most likely scenario.

All information contained herein is for informational purposes only. This is not a solicitation to offer investment advice or services in any state where to do so would be unlawful. Analysis and research are provided for informational purposes only, not for trading or investing purposes. All opinions expressed are as of the date of publication and subject to change. Astor and its affiliates are not liable for the accuracy, usefulness or availability of any such information or liable for any trading or investing based on such information. The investment return and principal value of an investment will fluctuate and an investor’s equity, when liquidated, may be worth more or less than the original cost. 310151-305

Fixed income outlook for a Fed hike

On Wednesday March 18th the Fed will have a quarterly Press Conference meeting. Since being instituted a few years ago these have quickly become significant as the meetings where new policies are announced. On I expect further measured progress toward higher short term interest rates. This note covers

  • My analysis of the Fed’s likely actions
  • What the short end of the fixed income market seems to be expecting
  • Implications for bonds

As always, there is considerable uncertainly but I think the market underestimates how much the Fed may raise rates.

Long and variable lags

The chart below shows where the economy is relative to the Fed’s dual mandate of full employment and stable prices. The horizontal blue area is a band around the Fed’s 2% inflation target and the vertical pink ribbon is the FOMC member’s estimate of the full employment rate of unemployment. The Fed adjusts monetary policy to nudge the economy toward the intersection of the two shaded areas. Considering where we were in 2010 and the criticism of their actions, we should admit that the FOMC has done a good job over the last several years.

FOMC dual mandate scorecard

Source: Bloomberg, FOMC, Astor calculations

Part of the difficulty with monetary policy is that there is a disconnect between cause and effect. The economy is not a pool table, with each action being in principle calculable from initial conditions. The Fed’s actions are subject to long delays the effects of last year’s easing or tightening works its way through the system.

For example, last week Vice Chairman Stanley Fischer said that the thought the effects of quantitative easing and forward guidance on the economy would not peak until 2016, this of a policy that began to be wound down a year ago. (see his speech or the underlying research) Imagine driving a car with an unknown delay between touching the brake and the car slowing and you will have the idea.

The end of forward guidance

Which brings us around to the question of why is the Fed talking about raising rates now? There are still people out of work, more working part time and still more who left the labor force in the great recession. Even though inflation is low, public comments by several members have led me to believe that it is the uncertainty about the timing of the effects of monetary policy, and the continued stimulus from QE which is still in the pipeline, that will cause the Fed to raise rates shortly.

An action consistent with a hike in the second or third quarter would be for the Fed to change its forward guidance language at the upcoming March meeting. According to Chair Janet Yellen’s recent congressional testimony, such a move will mean that a rate hike is possible, though not ensured at the next meeting.

The practice whereby the fed has been explicitly telegraphing its moves months in advance has been known as Forward Guidance, and is itself believed to be a very significant part of the Fed’s easy stance. That is, by giving strong suggestions, if not quite guarantees, about the future course of short term rates the Fed has shaped expectations which are such a key component to interest rates. This anomalous circumstance is likely to end in a few weeks and the Fed hopes to resume its accustomed inscrutability shortly.

The market’s expectations

Absent a rapid deterioration in the economy it is likely that the new hiking cycle since 2004 will finally begin in the summer or fall. I am concerned that the fixed income market, jaded by repeated disappointments of the Fed failing to raise rates, has convinced itself that the fed will not be aggressive when it finally does so. This chart shows forecasts of the fed funds rates from three sources. The lowest, red dots are derived from fed funds futures, the middle, blue dots are from a survey of primary dealers, the highest green dots are from a survey of FOMC members.

Forecasts of fed funds

Source: Bloomberg, FOMC, Astor calculations

There is a 85 basis point difference between the expected end of year rate for 2015 between the fed fund futures market and the FOMC with a larger difference the following year.

Repeated disappointments have led the market to doubt that the fed will be aggressive when it does begin to raise rates. Recalling the last two tightening episodes may be sobering. In both 1994 and 2004 the economy was slow to come out of recession – the recovery from the 1991 recession was the original “jobless recovery”. Signs of economic slack and tame inflation allowed the Fed to keep rates lower for longer in these recoveries. But when the fed raised rates it was far beyond what the market had anticipated, perhaps lulled by a lengthy period of easy money. In 1994 the market was expecting 100 basis points in two years and got 300 basis points in just over one. A similar mismatch between expectation and reality took place over the feds 425bp hiking jag starting in 2004.

It is hard to say how likely the Fed is to tighten aggressively. On the one hand uncertainty about the amount of slack left in the economy and low rates of other developed nations are likely to lead to a lower funds rate. On the other hand, the consumption-reducing rebuilding of balance sheets by banks and consumers seems to have been completed, leaving them better able to spend.

There is little theory to guide us. James Hamilton and his co-authors detailed recently that economists have not found a clear, empirical relationship between economic growth and a neutral real (that is, inflation adjusted) fed funds rate. We cannot generalize from economic growth or inflation dynamics to where the fed will stop raising rates once it starts.

In addition to fed funds rising, perhaps more and more quickly than the market anticipates, there are signs that some on the FOMC desire fiscal conditions as a whole to be significantly tighter. I am thinking here of two speeches by NY Fed President Bill Dudley who I see as being representative of the vital center of the committee. In a speech last year President Dudley said that the FOMC needs to pay closer attention to financial conditions and that if measures like the ten year yield moves in an easier direction while the Fed is tighten, then they may need to raise more aggressively to make the market get the message.

As always, my thoughts should be assumed to be seasoned with a heavy hand of humility, we can expect the markets to surprise us over the rest of 2015. However, with the Fed looking to raise rates with firm growth in the US, and a decent outlook overseas, I see a significant chance of a meaningful upward move in yields this year.