March 23, 2017
Taking the Shine off
The dovish hike that the Fed manufactured last week continues to calm the savage hawks that were circling around the concept of a more aggressive Fed. From our perch, we have to give the Fed kudos in providing itself with the most flexibility possible, including full optionality for an additional one to two hikes this year. The market's key takeaways have been the lack of "dot" creep within its projections, with median expectations remaining unchanged for two additional hikes in 2017 and an additional three in 2018. The March meeting also included an update to its economic projections, which also showed very little change in outlook, essentially signaling that the economy was evolving as expected. Within the policy statement itself, the key points indicated that the economy was moving along as expected with a strengthening business environment. Inflation was also headed in the right direction, although core readings were generally stable, thereby indicating a lack of urgency on the Fed's part. In framing the path of future rate hikes, as long as supportive financial conditions continue and data improves as expected, the Fed will move along its prescribed path, which remains accommodative and gradual. It did add the term "symmetrical" to its inflation discussion, hinting that inflation can run hot before the Fed feels compelled to change its outlook. The presser was much the same, with Yellen presenting a wait and see attitude with regard to any economic developments that may arise from policies emanating from the Trump administration. The broad message we interpreted is that normalization of monetary policy continues, with very little rush to change what the Fed views as a continuation of highly accommodative policy. While economic data may justify a more aggressive view later this year, current data indicates to us a Fed comfortable with an additional hike before mid-year and then waiting till later in the year before considering another move. This three hike view has become our base case, with a more aggressive position requiring survey measures of core inflation moving up sharply before the Fed contemplates deviating from its defined plan.
The immediate change in asset class values following last week's FOMC meeting were to lower yields and a weaker USD. The logic of pushing yields lower makes sense, particularly for a market that had become focused on a Fed that seemed to be tilting towards a more aggressive position. Fed speak and improving data led investors to this view, which was further supported by expectations of more debt and possible inflationary pressures from Administration initiatives. Instead, we heard from a Fed that appeared content to continue the normalization process, without an urgency of addressing expansionary fiscal policy as its priorities and efficacy remain opaque. Yields have since fallen between 12 and 20 bps since the Fed meeting with the belly outperforming the wings. The curve is therefore flatter through the 10 year, which runs somewhat counter to a less forceful Fed, which logically would steepen the curve on less aggressive rate hikes. However, with three total hikes still on the table for each of the next two years, there has not been a change in the overall message. What seemed to have changed was less of an imperative to get in front of tax and spending initiatives from Washington. This was a marked change from the last FOMC meeting, with minutes indicating a general unease that there was upside risk to its projections, although the lack of clarity made adjustments to its projections problematic. Instead, we heard from a Fed that felt comfortable waiting to see what was actually implemented by Congress and the Administration, which ultimately plays into the growing view that policy would have a longer ramp than initially anticipated, at a minimum.
Investors have struggled with the opacity of the Administration's agenda since before the elections, allowing different asset classes to focus on various aspects that best suit their views. We think fiscal spending and its impact on growing budget deficits have been the primary concern of rates investors. The currency markets have grabbed hold of the border adjustment tax as a catalyst for the stronger USD, while risk investors are encouraged by deregulation and fiscal stimulus. The Fed's measured approach to economic changes driven by the legislative agenda therefore shined a light on the lack of clarity on the timing and effectiveness of these initiatives. As mentioned, rates have rallied, as yields have retraced back to late February levels after hitting post-election highs just a few weeks ago. Treasuries have also outperformed other sovereign curves, as the yield differential between 10y treasuries versus both Bunds and JGBs narrowed between 10 and 13 bps over the past week. USD has subsequently fallen over 1% since the Fed in DXY terms and is now down almost 2% for the year. Most of the majors are therefore stronger versus the USD since the Fed, but gains have varied from +0.3% for the EUR to +2% for JPY. It is worth noting that many larger USD/EM pairs are outpacing the weakness in DXY, a possible indication of changing views in the Administration's agenda. We have attached a few charts that our FX strategy team has highlighted in their musings recently that show the relative underperformance of the USD given the yield gap between UST and Bunds/JGB that has opened up over the past month. While our custodial flow data had showed continued positive USD flows during this period of underperformance, it too has shown outflows recently. Since we think that the border adjustment tax has been a major catalyst for a stronger USD theme, a bogged down legislative agenda that delays discussion on this possibly divisive aspect of tax reform removes a short term catalyst to own dollars.
Risk assets have posted varying results, with stocks generally falling globally. US indices have led equity values lower, as the DJIA and S&P have fallen 1.5% in the last week, led by financials and energy. It is worth noting that small caps as measured by the Russell 2000 are down by over 3% in the past week, a possible indicator that the reflation trade is running out of steam. Euro exchanges are down between 0.5% and 1% during the past week, while Japan is underperforming versus China and Hong Kong thatare outperforming. Credit is also posting mixed results, with IG credit stable from a spread perspective, while high yield spreads are wider by 6bps. Hard currency EM was one of the stronger bond asset classes over the past week, with a 1.1% gain since the Fed meeting, which brings its monthly performance back to flat. Data is somewhat limited near the end of the month, with housing and durable goods the key releases in the coming week. We have had a precession of Fed speakers this week, including Chairman Yellen tomorrow and NY Fed President Dudley on Friday. While the markets can always move when Yellen speaks, we don't expect a change in message given we have heard her detailed views twice over the past two weeks. With the focus on Fed speak, we are also reminded that the composition of the Fed may change dramatically over the next year to 18 months. Already, Governor Tarullo has likely cast his last vote on the FOMC, increasing the number of vacancies to 3 on the board of governors. We will also note that Raphael Bostic joins the ranks of the FOMC as Atlanta's new President, replacing a retiring Dennis Lockhart. While Atlanta does not have a vote until next year, Bostic's economic and funds view will be incorporated into June's updates.
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