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Aon Retirement and Investment Blog

US Federal Reserve Guidance: Can its lift to markets last

Summary

  • Federal Reserve interest rate guidance over the last two weeks has emphasized the risks to the economic outlook as it seeks to move rates higher. The Yellen Federal Reserve has stressed that there are more risks to getting it wrong by tightening too early than raising rates too late. 
  • Interest rate markets have reacted accordingly, with a further flattening of rate rise projections. Treasury (and global) yields are down on the guidance, but the seeming tolerance of upside risks to inflation has led to break-even inflation rates moving a little higher and real yields moving lower. 
  • This latest dose of interest rate guidance has helped lift risky assets, though more through the impact on the US dollar and commodities than directly.
  • The stalling of the U.S. dollar rally and some stabilization in commodities offers relief to risky assets, particularly in areas sensitive to both. For the rally to continue and strengthen, however, we need evidence of stronger economic conditions. The dataflow here is still far from good. 
  • A trading environment with spikes in volatility continues to be in prospect.
Recent Federal Reserve Guidance
Three developments on Federal Reserve interest rate guidance have occurred in the past fortnight. In order of importance, these are as follows.
  1. The interest rate guidance from the Federal Open Market Committee (FOMC) of the Federal Reserve Board for its median projections was lowered. The projection of four interest rate rises in 2016 (0.25% each) was lowered to two. Virtually nobody in markets believed that raising rates every quarter this year was even a remote possibility. The long-run expected policy rate was also lowered again, this time to the lower 3's. This was also a little beside the point since the market has not priced in longer run rates anywhere near the Federal Reserve's projections for several years.
  2. The Federal Reserve lowered its growth and inflation projections for 2016 from its prior projections released in December 2015. Relative to projections issued one year ago, the numbers for both growth and inflation are significantly lower (see chart below). This was important, as it suggested a fair degree of caution on the economic outlook.
  3. The most important development was Janet Yellen's speech on March 29th.[1] Here, she pointed to the asymmetric conditions facing monetary policy – pointing out that there is far more room to raise rates than to cut rates. The inference was that there was more danger from tightening early than from tightening late. The global economic outlook was cloudier.

Source: Federal Reserve

The Reaction in Interest Rates Markets


Though some of the forward guidance was merely bringing down projections from what had clearly become untenable levels, it did have an impact on rates markets. The economic projections helped cement the message from the changed expectation on interest rates signaled by the Fed. That said, Janet Yellen's speech had the much bigger impact, as shown by the behavior of Fed fund futures. If you compare the red lines with the green lines pre and post the Federal Reserve announcement and Yellen's speech on the 15th of March and the 29th of March, respectively in the chart above, you will get the idea. The expected gradient of rate rises, already very shallow, flattened still further. 
 
The markets had been working on one likely rate rise in 2016 prior to the new guidance; the very fact that the Federal Reserve bought their likely path for rate rises down from a likely four to a likely two sowed doubt! As a result, the market is now expressing only a 50% or so probability that a rate rise occurs at all. In effect, the Federal Reserve's lowered projections have been fully matched by the market's own and much lower pricing, so that the gap between the Federal Reserve projections and the market still remains as wide as ever. This is especially so the further out you go in time. Markets remain very far even from the Federal Reserve's lowered 3.3% long-run Federal Funds rate projection.
 
What about the impact on longer duration bond yields? There is a marked move lower in yields post the Federal Reserve announcement (see charts below), but there is something quite curious about the move. Though yields are pulled lower by the combined force of the March 15th FOMC announcement and the follow up March 29th speech from Yellen (chart left), note the way break-even inflation rises (real rates, i.e. yields on TIPS fall more than those on fixed US treasuries). This arises because of the market's view that the Yellen speech signaled the Federal Reserve's lack of concern about inflation. The market has been noticing the pick-up in core inflation for a few months (see chart lower left).The Yellen bias toward a dovish stance signaled to the markets that the Federal Reserve was either of the view that the inflation pick up was temporary (some of it is coming from factors that the Federal Reserve cannot control directly anyway like healthcare and rents) or that even if inflation did pick up and stay higher, this would not bring commensurate monetary tightening. 
 
No wonder (see chart, lower right) that the bond risk premium, referred to sometimes also as the term premium, moved deeper into negative territory after already having been very low. This is tantamount to the bond market asking the investor to pay a premium to take long-term inflation or interest rate risk rather than the normal other way. Highly unusual, but then this is an extraordinary economic and market environment. We should remind ourselves that globally, just under 2/3rds of government bond market capitalization is showing yields of under 1% at this time and almost a third trades at below zero yields. 

Souce: Bloomberg

The Reaction in Risky Asset Markets
Yet again, risky asset markets seem to have benefited from the extra dose of Federal Reserve forward guidance on the longevity of ultra-easy money. Risky asset markets had been stabilizing through early March on the back of easing fears of a recession, but it was the cumulative impact of the Federal Reserve announcement and the Janet Yellen speech that gave much more durable support, particularly to US stocks. Just when it has seemed as though low interest rates and aggressively dovish guidance are losing their thrall on markets, along comes another example of its still considerable hold.
 
However, there is a difference this time. The positive impact has come not from more of the same on interest rates (this is hardly the first year that expectations of rising interest rates have been doused), but because of what it is doing to the US dollar. The apparent 'turn' in the US dollar has been important for risky assets generally – not just because earlier dollar strength had been clearly damaging for US equities, but also because commodities and emerging markets had been hurt by the rampant dollar over the past several years. The fall in the dollar from its highs has been less than 5% in trade weighted terms so far, but after an earlier 25% climb, it has been a big relief. Commodity stabilization has also been encouraged by signs of a lower supply overhang in crude oil. Much of the revival in high yield and emerging markets indirectly reflects this dual impact of a less rampant US dollar and the better tone in commodity markets.  Whether acting through the dollar, commodity markets or directly, Fed guidance has been a key factor lifting risky asset prices.
 
Can it Last?
Here is the difficulty. Let us suppose that the US dollar has peaked on an underlying basis. We have signaled this expectation recently. Let us also work with the view that the worst is over for commodities. We are also of this view. However, is this enough to durably lift credit and equities? It helps, but we have to remember three difficulties.

  1. First, we have no expectation that very much of the commodity price falls or the rise in the US dollar will reverse over the medium-term. It is stabilization rather than a big reversal we are talking about. The conditions driving commodity prices lower and the dollar higher have changed, but not so very markedly as to argue for a large reversal. This is relief, not reversion.
  2. Second, valuations are still investor-unfriendly, particularly in equities. They are rather better outside of the US, but some of this is for good reasons. The global equity valuation picture still shows that valuations offer limited scope for market growth, especially so with markets having recouped a considerable part of their earlier falls. Credit valuations did adjust to more attractive levels through the episodes of market turmoil over the past year, but here too, we have seen some big moves recently. US high yield spreads over treasuries have fallen over 200bps from levels over just a few weeks. Credit does offer better relative value to equities, but the big picture is that risk-asset valuations across credit and equities do not make long-term investors want to load up on risky assets now. 
  3. The third factor is the most important. This is the continued fragility of the macroeconomic outlook. For market gains to resume in earnest after about a year of range trading requires the continued drumbeat of weak economic news to ease. The big issue is the low nominal growth rates being seen around the world – downward forecast revisions for both GDP growth and inflation is the key problem. This clearly warrants caution around how much we can expect corporate top lines to grow. It is also not an environment where profit margins can compensate for slack top lines either which may explain why profits expectations continue to be scaled back. It is also a big constraint on credit given the sensitivity of credit quality to economic conditions and also because US corporations have re-leveraged considerably in recent years. There remains an uncomfortably high risk that the global economic slowdown rolls over into near or even outright recession conditions at some point over the next year or two. A durable risk-asset rally requires this risk to abate. We have to continue watching these growth revisions keenly to see which way the cycle is headed. We are hoping for a 'muddle through' but the conviction around the probability of the muddle through scenario is lower than it was a year ago.

We are then left with this. The Federal Reserve guidance has contributed to the better tone in risk-asset markets offering respite via currency and commodity markets. This is relief, but we need more to turn positive. Until then, we continue to expect a low return, trading market with volatility spikes to remain with us.  
 
Tapan Datta is the Head of Aon Hewitt's Global Asset Allocation team and is based in London.




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