Chief Investment Strategist
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For the first time since mid-2004, the Federal Reserve has begun a new monetary policy tightening cycle with a unanimous vote to raise the target range for the Federal funds rate to 0.25%-0.5% from 0.0%-0.25%.
- The response in financial markets was some immediate relief of the resolution to uncertainty over the Fed’s decision. This comes in the context of significant worry over broader international issues in recent days that depressed markets. We would be cautious, however, to assume that the initial impact in markets represents all of what will be felt across world markets in the days to come.
- The Fed continued to see a “solid” outlook for U.S. consumer spending, business investment and improving labor markets. It signaled “gradual adjustments” ahead for the Fed funds rate as consistent with continued U.S. expansion and improving labor markets.
- The median FOMC participant (voters and non-voters) expected a 1.4% fed funds rate at year-end 2016. Short-term fixed income markets price about 0.85% for that period. What is “gradual” for a Fed that considers 3.5% a “longer-run” normal Fed funds rate? This remains a key question.
- Fed Chair Yellen continued to reference a return to 2% inflation in the U.S. and a “leveling out” of unemployment in a manner that implies a misleading degree of control over the economy in our view. The U.S. economy cannot be so perfectly managed as the long-period of off-target inflation and unemployment in recent years suggests.
U.S. equity and credit markets appreciated and the U.S. dollar vacillated as the Fed lifted its key policy rate 0.25% today in perhaps the most anticipated monetary policy tightening step in history. However, financial markets will likely still need more than an afternoon to adjust to the reality of an actual Fed tightening cycle, however meagre it might prove to be by historical standards. Amplified by year-end illiquidity in some financial markets, reactions to the Fed may still illicit a response in world markets in coming days, even potentially reversing early movements today.
The short-term and long-term ramifications of the Fed’s decision are most likely to be judged differently over time. As discussed today at the Citi Private Bank Global Investment Committee meeting,the international backdrop of the past two weeks suggested an initially positive response to the Fed’s act of confidence.
In December todate, several issues that caused world markets to swoon over the past year re-emerged, and this time, simultaneously, depressing markets going into today’s decision (please see our Global Investment Committee Asset Allocation Statement for discussion).
The longer-term interpretation of the Fed’s steps is likely to exaggerate the impact of the Fed’s policy actions. The Fed added $3.6 trillion to its balance sheet at key moments during the past seven years. It seems doubtful that its balance sheet will shrink substantially before the next easing cycle and period of U.S. economic weakness. As figure 1 shows, central bank policy actions frequently lag turning points in economic activity rather than lead them.
As she often has before, at her press conference today, Chair Yellen noted that the Federal Open Market Committee expects inflation to return to the central bank’s target of 2% (full stop) almost as if this were the final point of a journey. The committee also forecast an unemployment rate of 4.7% in the coming year, and the same level in each of the following two years. This is despite a history that has durably shown that U.S. labor markets are in an almost continual state of transition from excess weakness to strength and back again (see figures 2-3). In essence, we are doubtful that the Fed will see its economic goals comfortably reached and sustained without excess or deficiency.
It’s Not Just the Fed
The Fed projects that its policy tightening cycle will persist at least through 2018. We are concerned over the simultaneous sustainability of both a Fed tightening cycle and U.S. economic expansion. Yet this is not an immediate concern in 2016 (please see “Outlook 2016” for our full view). As figure 4 shows, there are indeed beneficiaries from the Fed’s move away from zero. Post financial crisis, larger financial institutions have been required to hold large buffers of liquid assets that could be sold easily to meet obligations. This appears to have created an unusual divergence in the net interest margins of large and small U.S. banks (see figure 4). Short-term high grade debt securities have had very low yields in recent years, and the notion that the large-cap U.S. financial sector will benefit in the early stages of Fed tightening seems well placed.
In the coming year, we still see global credit risk tied closely to commodities (petroleum key among them), with only rather limited spillovers elsewhere. Those spillovers, however, can be as large as national economies (consider recessions in Russia, Venezuela and Canada’s growth struggles this year).
In the U.S. case, one should see that the challenge for credit markets is not just a large revenue drop for high cost oil producers. The build out of U.S. oil-producing capacity was significantly financed by raising outstanding U.S. high-yield energy debt ($190 billion compared with $10.5 billion at the end of 2001.) It is a combination of a large debt expansion that raised excess supply, helping to weaken the fundamentals to service debt. This is remarkably similar in scale to high-yield telecom sector’s pre-mature capacity boom in the 1990s (see figure 5). Just like the internet, we expect we will still have shale oil supplies and fracking in the future despite these booms and busts.
As a systemic risk, the U.S, energy boom seems far smaller than the rise of sub-prime mortgage lending in the 2000s (see figure 6). The absolute financing level is not just smaller overall, but appears largely held in the form of a risk asset class (high yield bonds) rather than a core asset of the banking system. The latter is also now capitalized in a dramatically different way than in the pre-crisis period.
In summary, we believe investors over-estimate the power of the Fed and underestimate the potency of the business cycle. While the Fed can provide easy or dear financing conditions, it doesn’t generate the real resources that are needed for economic growth. Rather than see the Fed’s tiny tightening step as a “policy mistake,” we see the U.S. capacity to grow as unfortunately more limited than the Fed’s very steady growth projections of coming years (again, please see “Outlook 2016” for our full view.)
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