Benjamin M. Lavine, CFA, CAIA
3D Asset Management recently updated its website, and as part of that exercise, we repopulated our library with previously published market commentaries and blog articles. Some of these articles have aged well, some not so much.
Since the Brexit decision in June 2016, we’ve published several articles discussing Fed monetary policy in the context of cyclical reflation versus secular disinflation (i.e. the New Normal). As we look back on what we wrote in the fall of 2016, it appeared to us at that time that the Fed had received the all-clear to start ‘normalizing’ monetary policy from the emergency measures (i.e. quantitative easing via balance sheet expansion, zero interest rate targeting) it had taken in response to the 2008 Financial Crisis.
And one could argue that the Fed has taken appropriate measures to normalize policy such as raising interest rates and paring back the balance sheet in response to a growing U.S. economy operating near full employment. First Trust’s Brian Wesbury has repeatedly argued that Fed interest rates should track nominal GDP, which would put Fed Funds around 3%.
However, following the Fed’s 2019 June meeting that affirmed the dovish tilt the Fed had telegraphed throughout much of this year, the Fed has, more or less, ‘admitted’ their mistake in raising the Fed Funds rate last December (and one that especially drew the ire of the Trump administration), when viewed in the context of a slowing (and now contracting) global economic backdrop. Even Wesbury acknowledges the Fed’s reticence to confirm the recessionary forecast signals of an inverted U.S. Treasury yield curve despite the Fed’s economic models and dot plot forecasts calling for policy normalization.
Fixed income investors have moved well ahead of the Fed with Fed Funds futures pricing in at least three rate cuts this year and a 1.25-1.50% rate by the middle of next year (Figure 1). The U.S. Treasury curve also remains inverted out to seven years, implying enough of an economic slowdown to warrant Fed easing. Inflation expectations implied by the U.S. nominal Treasury Yield-TIPS breakeven rate have also dropped to 1.8% in mid-May before recovering back to 2% (Figure 2). One could interpret the rebound in inflation expectations as stabilization in economic growth and inflation trends should the Fed follow through on rate cut expectations. The Fed’s ‘data dependence’ seems to be taking more of their cues from bond market pricing as bond markets have been conveying that the U.S. economy cannot handle ‘rate normalization.’
Figure 1 – Fed Funds Futures Pricing in At Least Three Rate Cuts Through Year-End 2019
Figure 2 – A Plunge in Inflation Expectations (5Y/5Y Breakeven Rate Priced Between TIPS vs Nominal Treasuries) in Mid-May and Subsequent Recovery Suggest Stabilization Should the Fed Follow Through on Expected Rate Cuts
Mission Accomplished (Sort Of)
Looking back at our 2016 Fed articles (theme: Mission Accomplished), we would posit that these articles have, on balance, aged well. If viewed solely within the context of the U.S. economy, the Fed’s pursuit of policy normalization was appropriate given the cyclical recovery, boosted by the 2017 Republican tax plan and Trump Administration deregulatory actions.
What hasn’t aged so well? Our assumption that the rest of the world, namely Europe and Japan, would also reverse quantitative easing, characterized by sovereign bonds priced to generate negative yields upon maturity. In our September 2016 article, we wrote:
“This week the Bank of Japan (BOJ) is expected to update its rate policy (a “comprehensive review of its negative-interest-rate policy”) as global central bank officials are starting to question the efficacy of negative interest rates to spur economic growth. As of the time of this writing, the BOJ chose to leave short-term rates unchanged but is committed to expanding its balance sheet “indefinitely” until inflation “overshoots” the 2% target as well as a long-term interest rate of 0% for the 10-year bond. Prior to the announcement in a quasi-reversal of current policy, BOJ officials were floating the idea of engineering a steepening of the yield curve where future balance sheet purchases would be concentrated on the front end of the curve (short-term rates) causing the back end (long-term rates) to rise which would improve the economics of long-term lending. These ‘trial balloons’ followed BOJ Governor Haruhiko Kuroda “acknowledging the downsides of his negative-interest-rate policy.”
Once the market moved past the Brexit vote in June 2016, where the worst-case fears of a market meltdown were not confirmed, both the BOJ and ECB had been contemplating exits from quantitative easing, sensing that negative interest rates were not producing the intended effects of boosting economic growth and inflation. Negative rates were (and currently are) pressuring bank profitability producing a less healthy banking system.
What has happened since the Brexit vote is that the U.S. economy has grown with strong employment while the rest of the world has lagged. Some of this is due to the ongoing trade conflict between the U.S. and China; one of the consequences of which has been a slowdown in global trade that has been particularly hard on countries that export into China (Japan, broader Asia, and Germany). Another fallout is the increased precarious state of China’s financial system, as indicated by high profile bank and property developer failures and widening credit spreads (Figure 3).
Figure 3 – Another Sign of Tightening Financial Conditions Across China’s Banking System
However, an equally-likely culprit (and one that Wesbury has begrudgingly come to accept) is a Fed monetary policy out of sync with the rest of the world. Higher real rates in the U.S. versus the rest of the world has led to U.S. dollar strengthening which is adversely affecting global liquidity and financing conditions. Figure 4 displays World Central Bank balance sheets as a % of local GDP. Note that the Fed’s exit from quantitative easing, resulting in a reduction in the Fed balance sheet, runs counter to Europe and (especially) Japan whose continued reliance on quantitative easing has produced, at best, economies that are barely treading water.
Figure 4 – World Central Bank Balance Sheets as a % of GDP; the Fed Remains Out of Sync with the Rest of the World
U.S. rate normalization may be appropriate within the context of the U.S. economy, but the U.S. does not operate in an economic vacuum. The U.S. dollar remains the reserve currency for trade flows and helps determine global liquidity and financial conditions. As the U.S. economy diverges from the rest of the world, the Federal Reserve finds itself increasingly as the world’s central bank. The dovish rate baton has been passed to the Fed from Europe and Japan.
Admittedly, serving as the world’s central bank is not in the Fed’s charter nor will Fed officials openly acknowledge this role, but the Fed has realized that plans for rate normalization have to be shelved until economic conditions improve across Europe and Asia.
The above is the opinion of the author and should not be relied upon as investment advice or a forecast of the future. It is not a recommendation, offer or solicitation to buy or sell any securities or implement any investment strategy. It is for informational purposes only. The above statistics, data, anecdotes and opinions of others are assumed to be true and accurate however 3D Asset Management does not warrant the accuracy of any of these. There is also no assurance that any of the above are all inclusive or complete.
3D does not approve or otherwise endorse the information contained in links to third-party sources. 3D is not affiliated with the providers of third-party information and is not responsible for the accuracy of the information contained therein.
Past performance is no guarantee of future results. None of the services offered by 3D Asset Management are insured by the FDIC and the reader is reminded that all investments contain risk. The opinions offered above are as of July 24, 2019 and are subject to change as influencing factors change.
More detail regarding 3D Asset Management, its products, services, personnel, fees and investment methodologies are available in the firm’s Form ADV Part 2 which is available upon request by calling (860) 291-1998, option 2 or emailing email@example.com or visiting 3D’s website at www.3dadvisor.com.