We wanted to offer a brief word of caution on fixed income markets that have been rallying so hard these last few days. There is no small amount of pain trades still being played out to be sure, but we would worry that the pricing is also based on either a very gloomy assessment of the growth outlook or in taking the recent chatter over a 2% “new neutral” seriously.
*** We think the Fed messaging on lower for longer rates and a slower for longer trajectory once the tightening is underway is being taken a bit too far, and that if it continues for much longer, it could elevate the risks of unwelcome volatility in correcting. In other words, it could become the very sort of market action that drew the warnings of Fed officials like the departing Governor Jeremy Stein when he delivered his influential speech on credit market risk taking behavior just over a year ago in St. Louis. ***
*** Underscoring that point, we believe that barring a substantial marking down in the central tendency forecasts, the projections for the year-end fed funds rates that will be published in the June and September Summary of Economic Projections are likely to still show a steady upward progression in anticipated rates, including the new projections for 2017. ***
We think there are three points to keep in mind.
First, each time Fed Chair Janet Yellen or any of her colleagues on the Federal Open Market Committee repeat the forward guidance takeaway of an economy that still needs ample accommodative support, they are simply repeating a message to ensure it sinks in, but they are NOT turning the dovish screw further and amping up even more of an accommodative messaging that would suggest pushing the first rate hikes into 2016, much less a tightening cycle that will never get much past 2%. Maybe they will at some point, but that is nowhere near the current FOMC consensus.
Second, before the Fed would be shifting to an even more dovish messaging, there would need to be a pretty substantial downgrade in the outlook, and we do not have any sense the Fed is downgrading its central tendency forecasts for 2014 and 2015. And on that score, the Federal Reserve Bank of New York this morning released its most recent staff forecasts that are still more or less in line with the CTF of near 3% growth this year, picking up to 3.5% next year. It is hard to reconcile that forecast with a collapsing neutral interest rate.
Again, many of the FOMC members, or more specifically, their staff, are nudging the assumed neutral level of interest rates down from the traditional 4% to perhaps as low as 3.5% in the longer run. Perhaps the better way to frame the “below normal” issue for now is that the neutral rate is not a fixed level but a variable changing as economic and financial conditions change.
That was point former Fed Chairman Ben Bernanke was at pains to make as far back as the September FOMC presser, not that it is currently plunging to a terminal rate of no more than 3%. So while it can be pushed down under the weight of the lagged effects of shock downturns to output, employment, and battered balance sheets or flat wage growth, it will also be rising again as growth gains pace and the transmission channels of policy are repaired and unclogged.
And third, there is the likely placing of the year end fed funds rate projections in the upcoming June and September FOMC meeting dot plots. As we said, unless the forecasts are being marked down pretty dramatically, there is no reason not to believe that the 2015 and 2016 rate dots won’t be nudged up a little more; after all, growth is expected to steadily regain the lost ground from the first quarter, and the labor market is still likely to show steady gains across its various measures through the rest of the year.
In particular the September dot plot will for the first time display the rate projections for 2017. And those dots — again, barring a reversal in the growth outlook — are likely to show at least some of the more hawkishly-inclined Committee members putting their year-end dots right up against 4% or more, while even the more centrist Committee members are also likely to mark dots that are clearly north of 3%.
On the value of the dots themselves, Chair Yellen and other Committee members have been playing them down a bit, drawing the distinction between the statement guidance versus the dots of the Summary of Economic Projections material going into an FOMC meeting. But the dot plots do nevertheless provide a useful sense of where and on what the Committee members and their staff are basing their discussions in the meeting itself that are ultimately fashioned into the formal, voted forward guidance of the statement itself.
As we mentioned in yesterday’s report (SGH 5/15/14, “Fed: Message Bifurcation”), we suspect that the plunge in yields and a pricing in short rates well under the Fed’s own projections on the timing and pace of rate increases may draw a gentle push back from Fed officials on some of the extreme misinterpretations gathering pace across the markets about the level of neutral or equilibrium rates.