ANDBANK RESEARCH Global Economics & Markets
Alex Fusté Chief Economist alex.fuste@andbank.com +376 881 248
Are you nervous about a possible shrinkage of the Fed’s balance sheet? Don’t worry. The Fed’s balance sheet always widen as Fed Chairman shrinks.
Working paper - 73 Fed Tightening: When. How. How long & Market Implications June 10, 2014
2
Corporate Review
Tightening – Why the discussion has begun? Admittedly, some at the Fed are sounding rather hawkish, maybe emboldened by the recent rise in inflation or the improvement in the unemployment rate (see the charts below). Is this the rebound in real activity and inflation that the Fed has strived for? Whatever the case, the Fed seems busy discussing both its exit strategy and the first rate hike. NY Fed’s Dudley, St. Louis’ Bullard or Philadelphia's Plosser, all have made hawkish comments and are inclined to begin raising rates early in 2015.
14
INFLATION - USA
14
12
12
10
10
8
8
6
6
4
4
2
2
0
0
-2
'81
'83
'85
'87
'89
'91
'93
'95
'97
'99
'01
'03
'05
'07
'09
'11
'13
-2
'12
'13
11,0 10,0 9,0 8,0 7,0 6,0 5,0 4,0 3,0 2,0
Unemployment Rate (Right) C ontinuing claims (millions) (Left)
(% 1YR) CPI All Item s US Department of Labor
Une mploym ent rate & Continuing Claims US 11,0 10,0 9,0 8,0 7,0 6,0 5,0 4,0 3,0 2,0 '04 '05 '06 '07 '08 '09 '10 '11
©Fact Set Res earch Sys tems
Andbank, US Department of Labor
©FactSet Research Sys tems
3
Corporate Review
Tightening – When…? In our view, later than sooner Our position (“later than sooner”) is based on three arguments: 1.
2.
3.
The growth outlook remains uncertain: Since January this year, the US OECD LEI* -Leading Economic Indicator- has shown a declining pace (see the chart below) suggesting that the US economy could be entering a period of softer growth. During the last 30 years, the US long bond has outperformed the US equity market whenever this US OECD LEI has lost steam (exactly as currently) what means that today the fixed income market also points towards a prolonged period of no-inflationary and sub-par growth rate. What really matters is Mrs Yellen’s view, and it is worth to mention that she has abandoned the idea of a threshold in unemployment rate (as the trigger for the first rate hike) in favor of a set of measures. This simply means that she always can find one indicator to delay a rate hike. Inflation expectations are not un-anchored: The spike in CPI has been fueled by a recent increase in items such as commodity prices or rents. Aspects that we consider could not have continuity, specially in the first case. Although rate hikes are needed (to put a more appropriate cost of capital), Mrs Yellen is unlikely to raise rates quickly unless CPI expectations become un-anchored. 8
So, When? Accordingly, and despite hearing those Fed’s members advocating for a rate hike in 1Q 2015, we see a rate hike more towards the end of 2015 rather than at the beginning of 2015.
US OECD LEI
8
6
6
4
4
2
2
0
0
-2
-2
-4
-4
-6
-6
-8 '04
'05
'06
'07
'08
'09
'10
'11
'12
'13
-8
(%1YR) Usa C li Le ading Indicato r Andba nk, OECD
* The survey that best tracks the factors that directly influence future economic activity, since it overcomes the survivorship bias that typically can be seen in the other surveys.
©Fa ctSet Research Sy stems
Corporate Review
4
Tightening – How & How long? How? As the New York Fed president William Dudley has recently stated, we are also inclined to the idea of “an increase in rates without starting to shrink the Fed’s balance sheet” How long? Once the Fed does start to raise rates (which we think will be clearly later than market consensus estimate), we admit that there will be a long way to go before short rates become restrictive (350 bp) according to the rule used by the Fed to set the “neutral” target rate”(see the Taylor’s expression below)
ir = P + r + a [p – p* ] + a [y -y* ]= 3.5% eq
t
t
p
t
t
y
t
t
ireq = neutral interest rate • Pt = current CPI (y/y)= 2% • rt = real rate assumed (in the Wicksellian rt = Real GDP) or 2.05% • ap = ay = 0.5 (so that for every 1pp increase in inflation, the Fed •
must hike rates more than 1pp in order to Var Real i.r >0, unique and effective way to cool the economy) Target CPI = 2%
p* = • y* = Potential GDP growth = 3% (Andbank estimate)
•
Corporate Review
Tightening – Market implications Core Fixed Income (Long US T-bond) – Stable: A rate hike without a shrinkage in the Fed’s balance sheet means that the bond market may not have to digest a sell-off in the Fed’s assets, and this should be welcomed news. So, considering that (1) the US OECD LEI suggest that growth is far from accelerating, (2) inflation expectations are not un-anchored, (3) rate hikes are unlikely to happen quickly and, (4) when the Fed will start, the move will likely be very gradual, we see no reason to forecast a significant increase in yields.
EM Fixed Income – Outperforming: Without a sell-off in sight for Treasuries, we see no reason to expect an underperformance in EM bonds.
US Equity market – Stable to Positive in the medium term: Admittedly, William Dudley’s words advocating for rate hikes could fuel fears and eventually trigger some sales in the shortterm (tightening policies always cause bear markets, while easing policies lead to booms. That’s how the system works). However, as far as market consensus realizes that a rate hike is unlikely to happen quickly, the equity market should remain sanguine, at least at first. With a longer term view, we should keep in mind that equities use to rise in the early stages of a Fed tightening cycle, rolling over around 18 months later (Will Denyer: “The end is in sight for zero US rates”).
EM Equity market – Outperforming.
5
Corporate Review
Legal Disclaimer All the sections in this publication have been prepared by the financial institution’s team of analysts. The views expressed in this document are based on the assessment of public and private information. These reports contain evaluations of a technical and subjective nature on economic data and relevant social and political factors, from which the financial institution’s analysts have extracted, evaluated and summarized the information they believe to be the most objective, subsequently agreeing upon and drawing up reasonable opinions on the issues analyzed herein. The opinions and estimates in this document are based on market events and conditions that took place before the publication of this document, and therefore cannot be determining factors in the evaluation of future events that take place after its publication. The financial institution may hold views on financial instruments that differ completely or partially from the general market consensus. The market indices chosen have been selected using the exclusive criteria that the financial institution regards as most appropriate. The financial institution cannot in any way guarantee that the predictions or events given in this document will take place, and expressly reminds readers that any past performances mentioned do not in any circumstances imply future returns; that the investments analyzed may not be suitable for all investors; that investments can fluctuate over time in terms of their share price and value; and that any changes that might occur in interest rates or currency exchange rates are other factors that may also make it unadvisable to follow the opinions expressed herein. This document cannot be regarded, under any circumstances, as an offer or proposal to buy the financial products or instruments that may have been mentioned, and all the information herein is for guidance purposes and should not be regarded as the only relevant factor when it comes to making a decision to proceed with a specific investment. This document does not, therefore, analyze any other determining factors for properly appraising the decision to make a specific investment, such as the risk profile of the investor, his/her knowledge, experience and financial situation, the duration or the liquidity of the investment in question. Consequently, investors are responsible for seeking and obtaining appropriate financial advice in order to assess the risks, costs and other characteristics of any investments they wish to make. The financial institution cannot accept any responsibility for the accuracy or suitability of the evaluations or estimates of the models used in the valuations in this document, or any possible errors or omissions that may have been made when preparing this document. The financial institution reserves the right to change the information in this document at any time, whether partially or in full.
6