RELEASE THE DOVES
Central banks remain the dominant story for the market as surprise dovish actions continue to frame most of the markets discussion. We will add South Korea, Thailand and Sweden to the rate cut bandwagon, which totals 23 by our count. Not all central banks have moved in the same direction, but hikes are few and far between and even no action, as in the case of Turkey and Indonesia this week, is viewed as just a temporary pause in the process. Hence, the Fed's action of signaling the impending rate hikes continues to stand out in the crowd. Today's message from the FOMC was within this context as they removed the "patient" term from the policy statement, marking the end of six years of forward guidance. Instead, the FOMC will now move to a meeting to meeting approach with regard to rate hikes, with the caveat that April will not be included in that formula. Of course, since no one expected April, this was effectively an empty statement used to show that the Fed is trying to remain on message, but in reality has reservations on its ability to actually raise rates quickly and aggressively. The initial thought that removing patient would signal a more hawkish position from the Fed is, and was, incorrect in our view, as we felt that their view on economic projections was more important. On this front, the Fed downgraded its GDP expectations for 2015, 2016 and 2017, while inflation expectations were also lowered for 2015 and 2016. As the table below indicates, economic growth was lowered to 2.5% in both 2015 and 2016, while core PCE is expected to remain below 2% through at least 2016. The path for Fed funds was also lowered, with 2015 expectations falling to 75 bps from 1.15%, while the expectation for the 2016 funds rate fell to 2% from 2.5%. If we delve a little more into these figures, one has to question the timing of any hike in 2015, which will move those expecting a June hike to move into September, while those expecting a fall liftoff may well start to look into 2016. Additionally, we view inconsistencies in the Fed's belief that it can raise rates in 2015 when its 2016 year-end inflation expectations stand at just 1.7%. We suspect that the market will need to digest these tid-bits for the next few days, but it certainly takes the sheen off of the straight line march to a stronger dollar and parity on the Euro.
BNY Mellon Weekly Fixed Income Market Commentary - March 19, 2015 March 19, 2015 20150319

BNY Mellon Weekly Fixed Income Market Commentary - March 19, 2015

RELEASE THE DOVES
Central banks remain the dominant story for the market as surprise dovish actions continue to frame most of the markets discussion. We will add South Korea, Thailand and Sweden to the rate cut bandwagon, which totals 23 by our count. Not all central banks have moved in the same direction, but hikes are few and far between and even no action, as in the case of Turkey and Indonesia this week, is viewed as just a temporary pause in the process. Hence, the Fed's action of signaling the impending rate hikes continues to stand out in the crowd. Today's message from the FOMC was within this context as they removed the "patient" term from the policy statement, marking the end of six years of forward guidance. Instead, the FOMC will now move to a meeting to meeting approach with regard to rate hikes, with the caveat that April will not be included in that formula. Of course, since no one expected April, this was effectively an empty statement used to show that the Fed is trying to remain on message, but in reality has reservations on its ability to actually raise rates quickly and aggressively. The initial thought that removing patient would signal a more hawkish position from the Fed is, and was, incorrect in our view, as we felt that their view on economic projections was more important. On this front, the Fed downgraded its GDP expectations for 2015, 2016 and 2017, while inflation expectations were also lowered for 2015 and 2016. As the table below indicates, economic growth was lowered to 2.5% in both 2015 and 2016, while core PCE is expected to remain below 2% through at least 2016. The path for Fed funds was also lowered, with 2015 expectations falling to 75 bps from 1.15%, while the expectation for the 2016 funds rate fell to 2% from 2.5%. If we delve a little more into these figures, one has to question the timing of any hike in 2015, which will move those expecting a June hike to move into September, while those expecting a fall liftoff may well start to look into 2016. Additionally, we view inconsistencies in the Fed's belief that it can raise rates in 2015 when its 2016 year-end inflation expectations stand at just 1.7%. We suspect that the market will need to digest these tid-bits for the next few days, but it certainly takes the sheen off of the straight line march to a stronger dollar and parity on the Euro.




Other changes to the statement confirm our dovish interpretation of the meeting. Their current view of economic activity was effectively downgraded to moderate from the solid pace that was cited in the January meeting. Additionally, the low inflation view remains constant rather than showing signs of improving, while the market based measures of inflation are little changed. The main change to the statement was altered to read as follows:

Consistent with its previous statement, the Committee judges that an increase in the target range for the federal funds rate remains unlikely at the April FOMC meeting. The Committee anticipates that it will be appropriate to raise the target range for the federal funds rate when it has seen further improvement in the labor market and is reasonably confident that inflation will move back to its 2 percent objective over the medium term. This change in the forward guidance does not indicate that the Committee has decided on the timing of the initial increase in the target range.    

Again, we will point to the need to see the committees view that it needs to be reasonably confident that inflation will move towards its 2% inflation target in the medium term as a potential challenge to a quicker than expected rate hike. The treasury curve had been adjusting away from its aggressive post-non-farm selling over the past week, with rates falling, while the curve flattened. The initial market reaction as we write this report is that investors are focusing on their view of the short end, pushing those yields lower to take into account a falling probability of earlier lift-off. The curve is also steepening for the moment, as the short end move has more momentum than the lower long term inflation expectation. We can see this steepening trend continuing in the near term as the futures market will likely push out its hiking expectations.

The extent of market dislocation around Fed lift-off continues to be something that we are watching closely. We had been skeptical that the market would smoothly transition to a tighter Fed despite their desire to clearly signal the upcoming change in policy. The IMF's Legarde stated as much this week, as she warned of heightened volatility around the lift-off process. As per Barrons:

The danger is that vulnerabilities that build up during a period of very accommodative monetary policy can unwind suddenly when such policy is reversed, creating substantial market volatility ... We already got a taste of it during the taper tantrum ... I am afraid this may not be a one-off episode. This is so, because the timing of interest rate lift-off and the pace of subsequent rate increases can still surprise markets." Chistine Lagarde at RBI meeting in Mumbai.    

We will see if a more dovish view of the Fed takes hold and whether this sparks a risk-on trade that has been largely absent during March. The volatility in the equity markets has trended 30% higher for U.S. stocks since the start of the month, as 100 point swings have become fairly common as of late. We view concern of USD strength as a large contributor to this weakness, as the S&P and DJIA have mostly lagged the NASDAQ and Russell indices. Further dissection of the laggards within these indices points toward the bigger multinationals with the most international exposure as lagging the more domestic focused business models. With the dollar significantly weaker since the release of the FOMC statement, we certainly can see strength returning to the risk markets. Equities have bounced hard since 2PM and are higher by over 1% versus the -0.6% it was posting before the Fed. A similar move has made its way to the credit markets, with both IG and HY spreads and levels tightening. This would also represent a reversal of the market trend that has seen spread widening in IG given strong new issuance and the decline in govie yields. From a new issue perspective, the first two weeks of March saw almost as much issuance as the entire month over the past few years. Since we don't expect issuance to slow down, we remain guarded over additional spread tightening, with the index fairly valued in the +130 range

High yield has also suffered from an active primary market, with the added challenge of waning fund flows. Flows had been positive since the start of February, as we saw the HY index improve from over 7% last December to under 6% at the end of February. In a sign of concern over the withdrawal of Fed liquidity we saw this index back up to 6.25% over the past few weeks on net fund withdrawals from both mutual funds and ETF. The HY market has also temporarily responded positively, although the recent downward pressure on oil will continue to impact high yield energy companies that have large representation within the index. By our records there have been only a few energy defaults, so the supply part of the equation has not yet been addressed. This seems to be the fundamental change that has driven prices lower, rather than another round of global growth concerns. We provide the following chart showing the yawning differential between WTI and Brent, which leads up to believe that the growth story remains stable, particularly in Europe which has a bigger influence on the price of Brent crude. 

We have limited economic data for the upcoming week, with mostly 2nd tier data. The trend of recent data has been mostly negative, with the economic surprise index at levels last seen in 2011. Additionally the table below indicates that most tier-1 data has missed expectations as of late. This index has a tendency to overshoot on both sides and given the more dovish view from the Fed and their apparent concerns over the slowing economy, economist may begin to capitulate on strong data and bring their estimates closer to actual data.

 

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