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Perspectives

Fed tightening continues

Steven Wieting

By Steven Wieting

Chief Investment Strategist

Kris Xippolitos, Global Head of Fixed Income Strategy

June 20, 2017Posted InInvestment Strategy, Investments and Fixed Income

At the June Federal Open Market Committee meeting, the Federal Reserve raised rates by 25 basis points (bps), as had been widely expected. The Fed also released details for reducing its balance sheet. Initially, the balance sheet will be reduced by no more than $10 billion each month – comprising $6 billion Treasuries and $4 billion Mortgage Backed Securities (MBS). This $10bn cap will rise every three months until it reaches $50 billion – made up of $30bn of Treasuries and $20bn of MBS. Any amount of maturing Treasury and MBS principal pre-payment that exceeds these caps would continue to be reinvested. Citi Research economists expect balance sheet reduction to begin in September. Since the Fed is unlikely to hike and announce balance sheet reduction at the same time, December becomes the most likely month for the next rate hike.

In our view, the initial amount of balance sheet reduction is relatively small. For context, QE3 – the third round of the US quantitative easing programme – amounted to $85bn of bond purchases per month before tapering started. The subsequent quarterly adjustments to the cap would likely be flexible and dependent on the prevailing conditions of the economy at that time. Despite the Fed's "hawkish hike", markets seemed to have paid more attention to the weakness in consumer price inflation and retail sales. This has served to keep both US Treasury yields and the US dollar lower than pre-data levels. These dynamics remain supportive of emerging markets.

A further interest rate hike should flatten the yield curve further and push LIBOR rates higher still. This is why we continue to recommend investors to hedge their floating-rate liabilities or identify assets which adjust to rising LIBOR rates (i.e. US bank loans). Of course, the timing of additional tightening could be delayed if global volatility spikes or inflation concerns resurface. Indeed, core consumer prices have been declining for the last several months, and the Fed’s main inflation gauge is still running below its 2% mandate.

As highlighted in CPB’s 2017 Mid-Year Outlook, higher long-term rates remains our main risk this year. A Republican-led government should eventually agree on tax reform at some point, which will reshape the US growth outlook. To be sure, fiscal expansion is likely the only way long-term yields rise meaningfully. Without reform, low inflation and limited high yield options elsewhere in the developed world, will likely keep the demand for US assets high and yields low. Therefore we maintain our neutral duration view in fixed income portfolios.