US measures of core inflation fell from February through May. The US reports June CPI at the end of the week. There is a reasonable chance that the core rate stabilizes. However, the movement away from the target has spurred expressions of caution from numerous Fed officials, even though the minutes of the June FOMC meeting showed that most officials recognized transitory factors weighed on prices.
A careful reading of Fed comments led us to conclude that a consensus on reducing the balance sheet was intact, though a consensus for another hike may prove more difficult until there is more evidence for the official suspicion. Hence we look for the FOMC meeting in a fortnight to only modestly tweak the statement. In September we expect the Fed to announce that it will begin implementing its strategy to gradually reduce its balance sheet starting in October. Depending on the evolution of the economy and inflation, a third rate hike for the year could be delivered in December.
For the same of this exercise, let’s assume that there is no chance of a hike before December. No chance may exaggerate it a bit, but probably not very much and it makes for a simpler exercise. Fed funds would likely trade around current levels, which is 116 bp on an average effective basis. This is what is averages for the first 12 days of December. On December 12, if the Fed were to hike rates, we should assume that the new effective average would by 25 bp higher or 141 bp.
That average could last 16 days to Friday, December 29. The effective average rate for the last trading day of the year typically falls post-crisis. Last year it fell by 11 bp. If we assume that the effective rate does the same thing this year, and recognizing that the Dec 29 effective average rate is the same for December 20 and 31, the weekend, Fed funds average 130 bp for the last three days of the month. When you do the math with these points, the outcome is an average of 130.25 bp for the month.
To conclude the exercise, recall that on no change in policy, the effective average rate should be what is today 116 bp. On a 25 bp rate hike, fair value is 130 bp. Currently, the Dec Fed funds contract is yielding 124.5 bp, or 8.5 bp of a possible 14 bp or about a 60% chance.
Another debate that appears to be intensifying among officials and investors is the relationship between reducing the Fed’s balance sheet and tightening. We have always been skeptical that a certain change of the balance sheet is tantamount to change in interest rates. Leaving aside economic theory for this unprecedented policy course and looking simply at what happened under QE, it appears that the anticipation and signaling effect was what spurred the decline in yields more than the actual buying. This seemed to be the conclusion of the ECB’s experience as well.
The impact of QE and the buying and holding will be the subject of white papers and dissertations, but it is not clear gradually reducing the number of Treasuries and MBS securities being allowed to run-off will have a substantial impact. It is true that the bonds that the Federal Reserve has been buying needs to be replaced by other economic participants. However, buying by financial institutions, households and the vast cash held by corporations, not to mention foreign investors, remains strong, which is why bond yields are lower now than when the Fed hiked last December or in March. Also, as we have noted, the US Treasury has recommended changes in the calculation of the leverage ratios, which would reduce the funding costs of Treasury holdings by banks.
There are two main thoughts about why interest rates are low. The consensus view emphasizes central banks activity. In our work, we have tended to lay more weight on slow growth, low inflation, and the surplus capital. The consensus argument lends itself to expecting interest rates to rise as the central bank’s withdraw from their extraordinary measures. However, stronger economic data and firmer price pressures encourage central banks to normalize policy. We note the secular decline in US bond yields since 1981 and the low point was reached not during QE, but after QE had ended and a gradual monetary tightening cycle had begun (July 2016, 1.32% for the 10-year note).