June Quick Read on the US Economy

The economic news softened somewhat from my last update.  The payroll numbers for May were especially weak, following a modest April.  However, we should not exaggerate one reading of a volatile series Overall the economy still looks like it is on a decent heading, but evidence has accumulated of at least a small pause in growth.  This is likely to make the FOMC  put off rake hikes.

 

Our Astor Economic Index® (“AEI”) shows growth is lower than last month, though slightly above this year’s lows posted in February.  However, I still see the US as growing above average today. 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.

usei.png

Source: Astor calculations

 

In remarks made on June 6th, Federal Reserve Chair Janet Yellen called the May jobs report “disappointing and concerning”  but she still believed that the fundamentals of the economy are strong.  I tend to agree with the Chairman.  How weak was the jobs report?  In the chart below, I averaged the last three month’s increase in payrolls to smooth out the numbers.    As a result, the increase in payrolls has dropped to an average of 116,000 jobs over the last March-May period.  For most periods since 2012, the increase in payrolls has been in the 175,000-250,000 range, though it has printed this low a few times.  At this stage in the recovery, the s that it will take only 70,000-90,000 jobs a month to keep the unemployment rate stable.  In my opinion the current jobs  report is poor but we need to see additional signs of weakening before we move from concerned to alarmed.

 

payroll.png

Source:Bureau of Labor Statistics

 

It is not just Astor Investment Management who is still seeing the growth picture as somewhat positive.  The nowcasts maintained by the Federal Reserve Banks of Atlanta and New York both show stronger growth than the first quarter.  The Federal Reserve Bank of Atlanta is currently estimating 2.5% and the Federal Reserve Bank of New York is estimating 2.4%.  Both have been updated since the employment report.

 

Where does this leave the Federal Reserve?  The market no longer believes that the June meeting is a real possibility for a rate hike anymore.  I agree.  In Ms. Yellen’s speech, mentioned above, she gave cases both for and against another hike.  The main case for hiking rates is that as long as inflation is expected to return to its target of 2%, in the medium term the Federal Reserve should soon raise rates slightly, so as not to have to raise them a lot later.  The case against another hike is that there is probably still additional labor market slack beyond the 4.7% unemployment rate and that inflation has spent very little time above what is supposed to be a symmetric target in the last ten years.  In addition, the inflation expectations seem to be drifting down slightly, something Ms. Yellen said she will be watching closely.

 

Should the payroll weakness continue or inflation expectations drift down further, rate hikes would likely be off the table.  If, on the other hand, those indicators show renewed signs of a strong economy then the Federal Reserve may finally make the second hike.  Will the election delay things?  The Federal Reserve wants to be seen as divorced from the political scene. The Federal Reserve moved rates in the summer or early fall in 3 of the last 6 presidential elections, not including the crisis year of 2008.  September 21st is another press conference FOMC so expect speculation to be attracted to that meeting, assuming no dramatic surprises in the economy.

 

Overall, I am concerned about the state of the economy and while I expect the last, weak payroll to be an aberration, I will be watching the numbers with more than usual interest next month.

 

 

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.

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March Quick Read on the US Economy

In my opinion, the latest numbers on the US economy were positive last month. After plummeting for the first half of February, stock markets became markedly more positive over the second half. International equity prices seem to have regained their footing and oil prices are well off the lows of the year as well. I still see the global growth environment as tepid: with the US being the main bright spot. Despite the international headwinds, I expect the Fed to begin to signal it will continue to tighten according to plan.

Domestic highlights in February

Our Astor Economic Index® (“AEI”) shows growth somewhat above the recent average and slightly 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.

I saw the employment report (nonfarm payrolls) for February as broadly positive. The number of new jobs was almost exactly at its two year average. I see no sign of broad based weakness in the economy when viewing the payroll numbers. Readers who want to burnish the negative case may have to dive into the weekly aggregate payroll. This number takes the number of employees and multiplies by the hours per week and again by dollars per hour. The result is something like a weekly wage bill and it posted a rare down month in February as hourly earnings and hours worked both posted modest declines.

In short: I think the pessimism in the first two months of the year were driven by fearful projections rather than data and that current views of the state of US economy are more realistic.

International environment

Last month, I was hoping for signs of strength in the world manufacturing cycle. It seems as if my hopes will have to wait at least until spring. While the Institute for Supply Management’s Manufacturing Index for the US showed a modest (but welcome!) bounce for the month, the picture in the rest of the world was not so rosy. The chart below weighs PMIs in roughly the G-20 countries, each one weighed by their GDP. This measure is looking for new low since 2012.

 

world.pmis.2016-03-04.png

Source: Institute for Supply Management, Markit, Astor calculations

The Fed

I believe the next red-letter day for the market should be FOMC Chair Yellen’s post meeting press conference on March 16th. Few expect the Fed to raise rates but many will be placing bets on the nature of the committee’s communications. Will the FOMC be hawkish or dovish? The Fed has repeatedly said they are data dependent and not tied to the calendar. However, as University of Oregon Economist Tim Duy has pointed out: we will need some clarity on which data they are dependent on.

In my view, the case for promising to raise rates again soon is that continued strength in the economy will move unemployment below the natural rate by a fair amount and perhaps for an extended period. In the view of Vice Chair Stanley Fischer for example, such labor market strength would risk setting off enough of an inflationary process that even larger rate hikes would be necessary to contain it.

However, I believe there are several complicating factors to give the Hawks a pause. First, is the tightening of financial conditions reflected in higher rates for corporate borrowers as well as the volatility and general decline of equity prices.  Second, inflation expectations, while hard to measure, may be declining. Inflation expectations derived from market prices are substantially lower than they were a year ago though survey-based expectations may have stabilized.  The chart below shows five year forward forecasts of CPI from surveys an derived from market prices.

infl.png

Source: Bloomberg, Federal Reserve bank of Philadelphia

My prediction is the Fed will raise not rates in either March or April and instead, focus on the tightening in the financial markets and weakness in inflation expectations in its released statement.  Therefore I am expecting the Fed to promise two or more hikes in 2016.   My preference (if I were a voter) would be for the Fed to make it clear that it is willing to be symmetrical around the 2% inflation target and would tolerate a year or two above the target as we have spent each of the last 8 years below it.

Conclusion

Overall, I am pleased to see continued growth in the US despite the tepid international environment. I expect the Fed to try to move back towards, but not fully achieve, its plan of four hikes this year.


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.

303161-375

February 2016 Quick Read on the US Economy

Our outlook for the economy deteriorated slightly in the last month.  Mainly our measures of output are showing weakness, while our measures of employment continue to show a solid recovery.  The risk is the manufacturing sector’s weakness spreads to the broader economy.  Most economists would agree the chances of this event happening are small, though we believe the chance is probably higher now than it was a few months ago.

Our Astor Economic Index® (“AEI”) shows growth somewhat above the recent average and slightly worse 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

A carefully constructed gauge of the current state of the US economy is GDP Now from the Atlanta Fed.  This uses current economic data as released to try and ‘nowcast’ the current quarter well before the official GDP release.  Currently, this model is seeing the data released thus far for this quarter as consistent with 2.2% GDP growth (SAAR), roughly what the Blue Chip Survey is forecasting.

The important point is that as of the end of January, and despite the concerns sketched above, we do not believe there are signs of broad economic weakness and we believe it would take some additional shock to cause it.

It is just possible we see signs of the end of the deterioration in the world economy. The chart below weights all the G-20 countries by their GDP to average their respective Purchasing Managers Indexes.  These indexes are constructed to show expansion in the manufacturing sector at readings above 50 and contraction below 50.  The world, as a whole, according to this measure may have stopped deteriorating in the last few months after falling steadily from the middle of 2014.

Source: Markit, Bloomberg, Astor calculations

Source: Markit, Bloomberg, Astor calculations

The world equity markets obviously do not agree, with virtually all major markets posting large declines year-to-date.  We believe stock markets can overreact to every worry – the old joke is that they have predicted ten of the last five recessions. A more uncertain world environment may argue for lower levels of earnings and a reduction in the amount investors are willing to pay for them.

On the other hand, the global economic weakness of the last 18 months or so is probably more notable for the dramatic reduction in the price of oil and increase in the value of the US Dollar.  Neither oil nor the dollar has extended those trends so far in 2016.   The first rule when you find yourself in a hole is: stop digging.  Perhaps these markets have stopped digging.  We believe a stable market environment for energy and exporters would be a good foundation for the economy to build on.

We think the financial market volatility has increased the likelihood the Federal Reserve will delay its next rate hike.  The increase in credit spreads over the last few months, for example, has made financial conditions tighter than they were when the Fed last hiked (as noted by NY Fed chair Bill Dudley here). One implication of that is the Fed may need to adjust the federal funds rate less, given this spontaneous tightening.

Fed Chair Janet Yellen testifies before congress on Wednesday, after this note is being composed.  She will presumably attempt to mention financial market volatility but likely be careful to avoid saying anything of interest.  I expect her to reiterate the consensus that the US economy remains intact and that history has shown the US to be resilient to foreign economic conditions.  She will likely say, like the last FOMC statement, that she expects to see economic conditions evolve in such a way as to make a gradual increase in the federal funds rate appropriate.

Overall, I am a bit more concerned about the US economy.  There may be signs of stabilizing in the international environment, but I will need to see a few more months before I breathe easier.  I expect the Fed to not make matters worse in the short run, but at the same time, I do not expect them to take steps to stabilize financial markets absent a dramatic swoon.


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. 

302161-365

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

 

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

November Economic Read

• Early indications are that October was another month of slow but positive growth in the U.S. and abroad. The monthly nonfarm payroll number for October was the strongest of the year, suggesting that weakness in August and September’s numbers was just noise. Emerging markets continue to be a small drag on the U.S. economy, but there are no signs of a crisis at this point. On the monetary policy view, the Fed continues to prepare the markets for tightening, perhaps at the December meeting.
• At 271,000 new jobs, the month-to-month change in nonfarm payrolls released in last Friday’s employment report was the strongest of the year. In addition, the year-over-year change in wages was as strong as it has been since the crisis, up 2.5% year-over-year. We can hope that wage gains hint at more of the economy’s gains accruing to average Americans to build a firmer foundation for a sustainable recovery. It is worth noting that as the expansion ages we can expect monthly employment gains to moderate and to see strength in the labor market represented as additional wage growth.
• On the international scene my view continues to be fairly strong growth in the developed world and faltering growth in the emerging world. Below, I plot the Purchasing Managers’ Indexes for the major international economies. For China (the epicenter of current concern) the PMIs stopped falling in October, though only time will tell if this level will be followed with renewed expansion or further deterioration. The economies most associated with exporting intermediate or raw goods to China (Australia, Taiwan, Hong Kong, Korea) continue to show contraction in the their PMIs. Indeed, these countries are seeing expectations of 2016 growth marked down. At the same time indexes ticked up in the Eurozone, the UK and Japan last month and a GDP-weighted average PMI increased in October.

International PMI heatmap

Source: Bloomberg, Markit, Astor calculations


• The Fed renewed its hold on investors’ attention last week with Chair Janet Yellen announcing the December meeting could mark the first raise in rates since 2006. Many of us are hopeful that whatever the other consequences, the first hike will at least mark the end of our long purgatory of waiting for the first hike. Focus should shift to the pace and ultimate extent of rate hikes. Given the uncertainty about the amount of slack in the labor market and inflation below target, I expect rate hikes to be much more gradual than in the 1999 or 2004 cycles. In addition, the FOMC members (who have consistently been too bearish in their rate forecasts since the crisis) currently see Fed Funds rate topping out at about 3.5%, well below previous cycles. Perhaps the tightening could be as modest as a two-year long move to a 2% Fed Funds rate
• Why is the Fed interested in rising rates? The FOMC seems to believe the labor market is close to full employment and that core inflation should move back to its 2% target in the next two years or so. Given the uncertain lags associated with monetary policy, the FOMC believes it is best to start to act now.
• Overall, I view the information released in the last month as supporting a slightly more optimistic take on U.S. 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. 311151-324

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.