All Things to Everyone
The markets awaited yesterday’s FOMC decision with great anticipation. When all was said and done, the Fed’s statement, as well as Ms. Yellen’s comments made during her press conference, was sufficiently ambiguous that one could interpret them as either more dovish or more hawkish simply by focusing on one sentence or another. Judging by the markets’ responses, it appears as though equity market participants consider the comments to be more dovish while fixed income market participants seem to view Fed language as more hawkish. The truth is that they could be interpreted as both hawkish and dovish when viewed in the context of potential scenarios.
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Contrary to expectations, the Fed did not remove “considerable time” from its statement. However, the FOMC statement and Ms. Yellen’s press conference statement stressed that the of course Fed policy is data dependent. The equity market focused on considerable time while the fixed income market focused on the data dependent comments. So who is correct?
They both are, but their time horizons are different. The equity market has a much shorter time horizon. It is focused on policy conditions for the next three to six months. The bond market is looking out more than a year. Given their different time horizons, both the equity and fixed income market views appear to be correct. As we are in the fixed income business, our focus is also “longer-term.”
And Your Bird Can Sing
One area which did appear more hawkish was the so-called “Fed Dots.” These are the forecasts of individual FOMC members. The average of these forecasts indicate a longer-than-anticipated (by the street) period of near-zero interest rates followed by a sharper tightening than what is anticipated by industry economists. The end results are similar, but the journey to higher rates is somewhat different.
The so-called “central tendency” (which excludes the three highest and three lowest projections) Fed forecast for economic growth anticipates that the U.S. economy should expand in a range of 2.6% to 3.0% in 2015, 2.6 to 2.9% in 2016 and 2.3% to 2.5% in 2017. The unemployment rate is expected to end 2014 between 5.9% and 6.0%, fall to a range of 5.4% to 5.7% in 2015 and average between 5.1% and 5.4% in 2016.
On the inflation front the Fed’s central tendency forecast anticipates inflation, as measured by PCE, to average between 1.5% and 1.7% for 2014, 1.6% to 1.9% in 2015 and 1.7% to 2.0% in 2016. Core PCE is expected to run at a similar pace. This begs the question:
If unemployment is expected to return to levels which have traditionally represented “full employment,” inflation is expected to barely rise to the Fed’s comfort level for inflation and GDP is expected to not quite return to trend (low-3.00% area), what does say about wage growth and consumption?
In spite of all the hawkish language embedded in the FOMC statement, the Fed’s forecasts do not portend an economy which should reach “escape velocity.” Equity markets have taken this to mean that the Fed will remain dovish. The fixed income markets are buying into the “new normal/new neutral doctrine.“ As such, the fixed income markets are of the opinion that the Fed will normalize policy without GDP averaging 4.0% and without inflation running significantly above its comfort level. However, it also probably indicates that growth and employment data the Fed considers “normal” have probably been ratcheted down. This is indicated in the FOMC estimates for the Fed Funds Rate.
The central tendency forecast for the timing for the beginning of Fed Funds Rate increases is mid-2015. However, the central tendency forecast also calls for a Fed Funds Rate of approximately 1.38%. That represents more aggressive tightening than the fixed income market is anticipating. As per the Bloomberg survey of economists, the Street consensus for year-end 2015 Fed Funds Rate is currently 0.95%. The Bond Squad estimate is a range of 0.75% to 1.00% for year-end 2015. The expected “terminal” rate for Fed Funds, as per the Fed Dots, is about 3.75%.(5)
Mad Dogs and Investors
Although we do not foresee a “tightening tantrum,” per se, a more dramatic rise in the Fed Funds Rates could catch some investors by surprise. High-risk and duration-sensitive investments could experience volatility when and if the Fed tightens more aggressively than markets anticipated, but this should be of little consequence for fixed income investors who have not over-extended in terms of credit and/or duration risk and can hold to maturity. For investors (and advisors) who understand what is happening, investing opportunities could present themselves. We will discuss this further in this weekend’s “In the Trenches” report.
Recent economic data has been mixed. It is this mixed data which has created much uncertainty regarding the course and pace of Fed policy. Yes, the current Fed has been exceptionally communicative, but yesterday’s message carried a note of ambiguity. Today’s economic data did little to clarify the situation.
Quadrophenia (can you see the real economy?)
Initial Jobless Claims for the week ended 9/13/14 came in at 280,000 versus a prior revised 316,000 (up from 315,000) and a Street consensus of 305,000. The four-week moving average of Initial Claims came in at 299,500, down from a prior 304,250.
Continuing Claims for the week ended 9/6/14 came in at 2,429,000. This was down from a prior revised 2,492,000 (up from 2,487,000) and lower than the Street consensus of 2,466,000.
The Labor Department reported that there was nothing unusual about the claims figures last week, but some economists have commented that claims data are difficult to adjust around holidays, and the previous week included Labor Day. The four-week moving average of Initial Claims was just a touch below 300,000. We believe that the low 300,000 area is the structural level for jobless claims at the present time. Jobless claims in this area should be consistent with monthly job growth of 200,000 to 225,000.
Jobless Claims data were encouraging. Housing Starts and Building Permits data were not. Housing Starts came in at -14.4% in August. Taking the edge off the negative number was an upward revision to July data, which increased to up 22.9% from an initial read of 15.7%. Annually, Housing Starts are on pace for 956,000. This is down from the July pace of 1,117,000 per year (up from 1,093,000). Building Permits (a proxy for future construction) came in at -5.6% versus a prior revised 8.6% (up from 8.1%). The Street had forecast a decline of 5.2%. The result was the annual pace of Building Permits fell to 998,000 from a prior revised 1,057,000 (up from 1,052,000).
As has been the case since the financial crisis, multi-family housing was the driving force behind the numbers. Multi-family Housing Starts fell to an annualized 313,000 from a prior 458,000. This was the lowest level since 268,000 in August 2013. After several years of strong multi-family home construction, to satisfy demand from Americans who have decided that homeownership isn’t an option due to slow wage growth, difficulty qualifying for mortgages and because they prefer amenity-filled urban units, they pace of multi-family might be platueaing.
The Philadelphia Fed Business Outlook fell, but still remains firmly in positive territory. The Philly Fed Index came in at 41.5 versus a prior 45.0. Prints over 0.00 indicate business optimism. Most components were up moderately, but the Philly Fed data indicated that the employment component jumped to 21.2 from a prior 9.1. Taking the edge off the positive employment data was that the average workweek fell to 4.4 from a prior 13.3. We interpret this job-related data to indicate that while more workers were added to payrolls, the majority of hiring might have been of the part-time variety.
By Thomas Byrne – Director of Fixed Income – Investment Consultant
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.
- November 2012 – Present, Wealth Strategies & Management LLC, Stroudsburg PA
- December 2011 – November 2012 – Bond Squad, Kunkletown, PA
- April 1988 – December 2011, Citigroup and predecessor firms, New York, NY
- June 1986 – March 1988 – E.F. Hutton, New York, NY
Director of Fixed Income
Wealth Strategies & Management LLC