Orlando's Outlook: Fed finally closes the loop

09-22-2017

Bottom line After nearly a decade since the start of the Great Recession in December 2007, the Federal Reserve announced on Wednesday that it would begin to gradually and systematically shrink its massive $4.5 trillion balance sheet starting in October. That effectively checks the final box on Fed Chair Janet Yellen’s punch list before her term expires in February.

True, concerns about stagnant inflation restrained the Fed from hiking interest rates again this week. But in a somewhat hawkish turn, the Fed intimated that inflationary pressures may be perking up and that a quarter-point rate hike in December—and perhaps three more in 2018—are on tap.

In our view, none of this should have caught the financial markets by surprise, and benchmark 10-year Treasury yields have been soaring over the past fortnight, from an overbought cycle trough of 2.01% on Sept. 8, to nearly 2.29% on Wednesday. So with economic and corporate-earnings growth accelerating, the Fed withdrawing accommodation and Treasury yields rising, we also may witness the hapless U.S. dollar—which has lost 17% of its value versus the euro this year—catch a bid soon.

With the S&P 500 up 20% since the election (hitting a new record high of 2,508.85 Wednesday), this confluence of events could help to spark another moderate 3-5% seasonal third-quarter correction, which we have been anticipating. But that correction window is rapidly closing, and we expect a year-end rally to start by the end of next month.

Shrinking the Fed’s balance sheet The Fed grew its balance sheet from less than $900 billion before the financial crisis to its current peak total of $4.5 trillion, comprised of about $2.8 trillion in Treasuries and $1.7 trillion in agency debt and mortgage-backed securities (MBS).

After its policy-setting meeting concluded on June 14, 2017, the Fed published its “Addendum to the Policy Normalization Principles and Plans,” in which it proposed a detailed schedule to formulaically shrink the balance sheet by decreasing its monthly reinvestment of principal payments it receives from maturing securities:

  • Starting in October, the Fed plans to withdraw a monthly cap of $10 billion from the reinvestment process, with the mix comprised of $6 billion in Treasuries and $4 billion in MBS.
  • Over the course of calendar 2018, the cap will increase by $10 billion every three months (by $6 billion each quarter in Treasuries and by $4 billion in MBS), reaching a maximum level of about $50 billion ($30 billion in Treasuries and $20 billion in MBS) in monthly maturities.
  • So by the end of calendar 2020, by our count, the Fed will have stopped reinvesting a total of $1.634 trillion ($972 billion in Treasuries and $660 billion in MBS), reducing the overall size of its balance sheet from $4.5 trillion to $2.886 trillion.

Importantly, while the Fed has not provided us with either a target date or a financial goal at which it intends to complete the balance-sheet shrinkage program, our best guess is the Fed wishes to gradually reduce the size of its balance sheet to about $2.5-3 trillion. We believe it will establish this range as its “new normal.” So, at this prescribed pace, it likely will take the Fed three or four years from now to achieve its goal. We also believe policymakers would like to focus on eventually reducing the MBS side of the balance sheet to zero over time, leaving them with an all-Treasury portfolio, which would require the Fed to orchestrate a mix shift at some point in time.

What could go wrong? While we’re not expecting the prospect of a recession before the 2020-2021 period, how might the Fed respond if a Black Swan event changed the pace of economic growth during the balance-sheet shrinkage program? The Fed said that if there was a material deterioration in the economic outlook, it would simply correct course, reducing the fed funds rate and reinvesting principal payments received from maturing securities on its balance sheet to keep rates low.

Next rate hike on hold for now, awaiting stronger inflation By focusing on balance-sheet shrinkage now, we believe the Fed is trying to buy itself a few months for firmer inflation data, to more comfortably orchestrate a quarter-point hike in December. This would be its fifth move in this cycle. At present, the Fed envisions three more quarter-point hikes in 2018, two more in 2019 and one final one in 2020, which would take the fed funds rate up to its prospective terminal rate of 2.75%.

  • The core personal consumption expenditures (PCE) index The Fed’s preferred measure of inflation has fallen from 1.9% on an annualized year-over-year (y/y) basis in January and February 2017 to 1.4% in July, a level expected to be matched in August when reported on Sept. 29. This metric is clearly moving in the wrong direction from the Fed’s oft-stated and aspirational 2% core inflation target.
  • The core wholesale producer price inflation (PPI) index This measure, which strips out food, energy and trade, spiked to a 2.1% gain in April and May from 1.6% in January, but slipped back to 1.9% in July and August. However, the nominal August reading perked up to a month-over-month (m/m) gain of 0.2%.
  • The core nominal retail consumer price index (CPI) inflation This metric, which strips out just food and energy prices, fell to a 1.7% increase in each of May, June, July, and August, down from 2.3% in January, which had matched its highest reading in four years. But the nominal m/m reading rose 0.4%, its strongest reading this year.
  • Wage growth This has been mired at 2.5% y/y growth in June, July and August, down from 2.9% growth in December 2016, despite an otherwise solid labor market with a low unemployment rate (U-3) of 4.4%.

‘Taper Tantrum’ revisited? The spike in benchmark 10-year Treasury yields over the past two weeks from an overbought 2.01% to almost 2.29% reminds us of the bond market’s infamous “Taper Tantrum” in May 2013. Then-Fed Chair Ben Bernanke told investors that once economic and financial-market conditions sufficiently stabilized in the aftermath of the Great Recession, the Fed needed to achieve three monetary-policy objectives:

  1. Begin to taper the Fed’s $85 billion in monthly bond purchases
  2. Lift off from the Fed’s zero interest-rate policy (ZIRP), having cut rates down to zero more than four years earlier
  3. Begin to unwind the Fed’s growing balance sheet, and liquidate mortgage-backed securities

Benchmark 10-year Treasury yields soared in the immediate aftermath of Bernanke’s comments, nearly doubling in yield from 1.6% in May 2013 to 3% in early September 2013. Over the balance of 2017, then, we still believe that benchmark 10’s could rise from their recent 10-month lows just above 2% back up to about 2.40-2.60%, and perhaps retrace the “Taper-Tantrum” peak from 2013 of about 3% by the end of 2018.

Currency and commodity volatility Since the election, the dollar has lost 17% of its value against the euro, from 1.03 to an oversold 1.21 recently, as European economic growth has accelerated, and questions surrounding Fed policy have grown. But with economic and corporate earnings growth now accelerating in the U.S., and with greater certainty surrounding the Fed’s policy intentions, we could see the dollar start to narrow that chasm, perhaps rallying back to 1.13 over time.

Gold prices leap nearly 13%, from $1,210 per troy ounce in the beginning of July to a 1-year high of $1,362 in early September, in a massive flight-to-safety rally. But gold has more recently retraced 5% of that gain, falling to $1,300 per ounce.

In the immediate aftermath of Hurricane Harvey in August, which took 25% of U.S. refining capacity offline in the Gulf of Mexico, gasoline prices nationally spiked by 15%, from $2.33 per gallon just before the storm hit to a peak average of $2.67 in early September, with many areas experiencing more extreme price spikes of 50 to 70 cents per gallon, with some stations running out of fuel. But prices have started to recede, so the hit to discretionary spending should be temporary.

Fed’s leadership transition risk grows Janet Yellen’s term as Fed Chair is set to expire at the beginning of February 2018. She used her keynote speech at the Fed’s annual monetary policy symposium in Jackson Hole, Wyo., in August to deliver an academic speech on the wisdom of the federal government’s post-recession regulatory efforts, which, in our view, reduced the odds that President Trump—who does not appear to have any problems with the dovish Fed Chair’s views on monetary policy issues—would appoint her again. In addition, Fed Vice Chair Stanley Fischer surprised investors by resigning earlier this month (effective Oct. 13), well ahead of his term expiring in June 2018. Adding Fischer’s departure to the three existing openings on the Fed and you get more leadership-transition risk if Yellen does not serve another term.

Yellen finishes checking off her to-do list Knowing she may not have a second term as chair, we believe Yellen has been actively managing her to-do list:

  • Complete the tapering process of the Fed’s $85 billion in monthly bond purchases that was started by Chairman Bernanke in late 2013 just before he retired, which she accomplished by the end of 2014
  • Lift off from ZIRP, which she accomplished with her first rate hike in December 2015
  • Begin to shrink the Fed’s $4.5 trillion balance sheet, which she accomplished on Wednesday
  • Avoid a double-dip recession, which we believe is still several years away

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