December is fast approaching. No, not December 25th, December 16th! Yes folks that is the date of the next FOMC rate decision. What makes this FOMC meeting special is the Fed might actually raise the Fed Funds Rate (albeit modestly). The minutes of the October FOMC meeting clearly indicated that, barring a significant negative event, the Fed is likely to finally “lift off.” Following the release of the minutes, last Wednesday, yields of long dated U.S. Treasuries headed lower.
Stop rubbing your eyes. You read correctly. The yield of the 10-year U.S. Treasury note and the yield of the 30-year government bond dropped following the release of the FOMC minutes. Why did long rates decline when the Fed will probably begin tightening in December? The answers could be found in the opening paragraphs of the FOMC minutes:
“The staff presented several briefings regarding the concept of an equilibrium real interest rate--sometimes labeled the "neutral" or "natural" real interest rate, or "r*"--that can serve as a benchmark to help gauge the stance of monetary policy. Various concepts of r* were discussed. According to one definition, short-run r* is the level of the real short-term interest rate that, if obtained currently, would result in the economy operating at full employment or, in some simple models of the economy, at full employment and price stability. The staff summarized the behavior of estimates of the short-run equilibrium real rate over recent business cycles as well as longer-run trends in real interest rates and key factors that influence those trends. Estimates derived using a variety of empirical models of the U.S. economy and a range of econometric techniques indicated that short-run r* fell sharply with the onset of the 2008-09 financial crisis and recession, quite likely to negative levels. Short-run r* was estimated to have recovered only partially and to be close to zero currently, still well below levels that prevailed during recent economic expansions when the unemployment rate was close to estimates of its longer-run normal level.”
“With respect to longer-run trends, the staff noted that multiyear averages of short-term real interest rates had been declining not only in the United States, but also in many other large economies for the past quarter-century and stood near zero in most of those economies. Moreover, economic theory indicates that the equilibrium level of short-term real interest rates would likely remain low relative to estimates of its level before the financial crisis if trend growth of total factor productivity does not pick up and if demographic projections for slow growth in working-age populations are borne out. Finally, the staff discussed the implications of uncertainty about the level of the equilibrium real rate for using estimates of short-run r* as a guideline for appropriate monetary policy.”
Bond Squad Translation:
The so-called equilibrium or neutral Fed Funds Rate is probably lower than what was typical during economic expansions of the past. The current appropriate policy rate is still near zero. Although the Fed might wish to raise policy rates, it probably does not need to move them quickly or dramatically. That neutral policy rates are probably lower now than they were in the past is not surprising as this has been a quarter-century trend and is probably due more to structural rather than cyclical forces.
Any bond market participant worth his/her seat on a desk knows that Fed policy usually responds to inflation pressures. A modest rise probably indicates modest inflation expectations. Modest inflation expectations probably results in fairly contained long-term rates. The FOMC minutes clearly state the inflation forecasts of Fed staffers (analysts and economists):
“The staff's forecast for inflation in the near term was revised up a little, reflecting recent data, and it was unrevised over the medium term. Energy prices and prices of non-energy imported goods were expected to begin steadily rising next year. The staff projected that inflation would increase gradually over the next several years but would still be slightly below the Committee's longer-run objective of 2 percent at the end of 2018. However, inflation was anticipated to reach 2 percent thereafter, with inflation expectations in the longer run assumed to be consistent with the Committee's objective and slack in labor and product markets projected to have waned.”
Fed staffers believe that inflation will not return to its longer-run objective of 2.00% until after the end of 2018. Fed staffers also expected GDP to expand at a somewhat faster pace than potential output from 2016 through 2018. What does this mean? My guess is; staffers are expecting GDP to rise into the mid, possibly high, 2.00% area. The Bloomberg Survey of Economists forecasts 2.5% GDP for both 2017 and 2018. The survey also forecasts Core PCE (the Fed’s favored measure of inflation) to run at 1.7% in 2016 and 1.8% in 2017. I hope the economists are correct, but I remain unsure at the present time.
Alright, If GDP growth is expected to be good (nowhere near overheating), inflation is expected to remain tame and Fed tightening is anti-inflationary (which is what it is), why should we see higher long-term U.S. Treasury yields? Add into the equation; demographic demand for bonds and higher rates in the U.S. versus foreign sovereign debt rates (accommodative monetary policy probably has many years to run in Europe, Japan and, possibly, China) and there is not much impetus for long dated interest rates to rise significantly, if at all.
As much as I would like to believe I am uniquely-talented, there are a multitude of knowledgeable, even brilliant, fixed income market participants in the industry (which is why I laugh when I read comments which state that the bond market is “mispricing” or is “wrong”). The bond market has been pricing in moderate growth, manageable inflation and a cautious patient Fed. According to the FOMC minutes, we should expect moderate growth, manageable inflation and a cautious patient Fed.
If anything, due mainly to some central bank selling of long-dated treasuries and selling by unadvised or ill-advised retail investors, long-dated U.S. Treasuries might be overstating long-term interest rate expectations.
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