Late yesterday (thanks to Bloomberg, 20 minutes ahead of schedule) the Fed released the minutes of the July FOMC meeting. The minutes indicate that Fed officials are divided into three main camps. They are:
- Those who believe conditions for tightening have been met.
- Those who do not believe conditions have not been met, but will soon be met.
- Those who believe that conditions have not been met and are unsure when they will be met.
Now the debate that is raging among economists is: Will the Fed tighten or be able to tighten in September? I believe that, before one can make a Fed tightening forecast, what one must question first is: Does the Fed need inflation to return to 2.0% (as measured by the Fed’s favored gauge, Core PCE YoY) before it tightens.
At first blush, it would appear that the answer is “no.” That might be a hasty answer. At last look, Core PCE YoY ran at a 1.3% pace. Given the global economic backdrop, chances of it rising to 2.0%, by September, December or even September 2016 are slim. However, given the weak global economic backdrop, the Fed needs to restock policy ammunition.
Also, ZIRP might be appropriate for a severe economic contraction and it might be appropriate to stimulate the economy during a recovery from a severe downturn (that is debatable), but it is more difficult to argue that ZIRP is appropriate for an economy growing at just above 2.0%. This is not to say that accommodative policy is no longer necessary, but ZIRP does appear to be overkill for the economy at the present time.
Because of the need to replenish policy bullets (just in case foreign central bankers/governments lose their grips on their respective situations), I believe it is possible that the Fed tightens (at least once) without inflation reaching 2.0% as measured by Core PCE YoY.
This is something that many investment committees around the Street appear to be discounting, but something which has gained traction among fixed income strategists and economists around the industry during the past 24 hours. I have stated the possibility of a Fed liftoff with inflation below 2.0% several times in the preceding months. I believe too many Fed-watchers are fixated on what the Fed has done in the past and are paying too little attention to how (and how much) the current situation is different from the past.
The Good, the Bad and the Different
The problem with strategizing now is that we have a dichotomy in the global economy. We have the U.S. going north (at a moderate pace) and the rest of the world going south (at a rapid pace). This sets up a very unique situation (unprecedented, really) for the Fed. If it does not tighten, it risks not having the policy ammunition to combat the effects of a deep global recession.
If it tightens, it could compound the disinflationary effects from a global recession by strengthening the U.S. dollar. The Fed could also worsen the situation for emerging economies dependent on exporting. However, the Fed should only be concerned about foreign economies as far as how they might impact the U.S. economy. The Fed has been backed into a corner. However, when even the most timid animal is cornered, it can act unpredictably and act more aggressively than it might otherwise.
In my estimation, odds of a September liftoff for tightening are about even. If pressed, I would say that chances are slightly greater for a September tightening than not. However, whether the Fed lifts off in September, December or early 2016, I doubt it is the start of a “tightening cycle.” In my opinion, Fed Funds Rate hikes are likely to be small and sporadic during the next several years and could top out in the 1.75% to 2.25% area before the Fed begins easing again.
It really depends on how much structural economic reform (as opposed to increasingly ineffectual monetary policy accommodation) occurs around the globe. I do not envision such reforms happening until politicians are faced with no other alternatives. Thus, the global economic slowdown could be a persistent theme over the next year or two (or three).
The question now being asked is: With the plunge in emerging markets assets, a crash in the commodities markets and spread widening in the corporate credit markets, is this a time to add risk? I do not think so, but it might be time to add “spread.” Credit spreads of A-rated corporate bonds are about 50 basis points wider versus UST benchmarks than they were this time last year.
At the same time, the 10-year Treasury yield has fallen about 50 basis points since this time last year. Thus, A-rated corporate bonds yields remain at similar levels as a year ago. This makes them relatively attractive (where investor suitable) at the present time.
This might be a “dip” worth buying. A similar (but more aggressive) situation exists among BB-rated corporate bonds. In the current market environment, I believe it advantageous to have the ability to pick one’s spots rather than take blanket positions in broad sectors. I will discuss this further in this weekend’s “In the Trenches” report.
Widening credit spreads have vexed many investment strategists as the group think among investment committees was to expect credit spreads to narrow when the Fed tightened. This has been the typical response to tightening in the past.
However, traditionally the Fed tightened when the economy was beginning to overheat and inflation pressures were trending above the Fed’s comfort level. Today, the Fed is considering tightening late in an economic cycle and when inflation is running well below the Fed’s comfort zone. As the Fed tightening situation has changed, the response of some asset classes to Fed tightening has changed.
I have stated for (at least) two years that the credit market’s response to Fed tightening would probably result in spread widening. Some readers have congratulated us for seeing what few others did not. Truthfully, special abilities were not required. All one needed were two good eyes, two good ears and the ability to think for oneself. I will publish more on investment strategy in this weekend’s report.
About Thomas Byrne
Thomas Byrne brings 26 years of financial services experience to Wealth Strategies & Management LLC. He spent the last 23 years as Director of Taxable Fixed Income for Citigroup, Inc. and predecessor firms in New York, NY. During the course of his long fixed income career, Mr. Byrne was responsible for trading preferred stock, corporate bonds, mortgage backed securities, government debt, international debt and convertible bonds. Mr. Byrne was also responsible for marketing, sales, strategy and market commentary within the taxable fixed income markets.