Looking through the latest headlines, three interconnected themes will likely continue to determine the path of US interest rates in the medium term:
- US tax reform,
- Monetary policy normalization by the Federal Reserve
- Reduction in the size of the Federal Reserve's balance sheet.
After the US election, it seemed animal spirits were overcoming the inertial forces
Expectations for tax reform legislation and other pro-growth fiscal policies are quickly fading. In the weeks following the US election, fiscal stimulus was identified as the tide that would lift all boats and caution was thrown to the wind as deflationary concerns quickly abated. The broad shift in sentiment appeared to overcome the inertial forces that have constrained global growth since the great recession.
but then the post-Trump election euphoria collided with reality...
Dreams collided with reality as the republican health care bill failed to garner enough support in congress to warrant a vote. While House Republicans were able to successfully pass a subsequent bill, the Senate has opted to craft their own legislation which will further extend the timeline. The failure of the republican healthcare bill has significant implications for US tax reform as revenue gains from Trump-care were expected to offset revenue losses from potential tax cuts. The Trump reflation trade has sustained a heavy blow. While market reaction was more pronounced in fixed income than equity markets, substantial momentum has been lost.
Looking ahead, bond markets are not optimistic...
Whereas markets have been anticipating future changes, the US Fed has been operating in the present. Recent changes in monetary policy were largely in response to improvements in current labor and inflation data. Absent a major change in fiscal policy, investors expect normalization to occur at moderate pace. Market based measures suggest that Fed policy rates will peak at roughly 3.00% which is broadly consistent with the Fed projections. Forward curves are forecasting a significant reduction in the term structure as the terminal rate nears (see Exhibit 1 below). This flattening of the yield curve has typically been interpreted as a signal of waning confidence in the economic outlook and elevated recession risk. Admittedly, market projections may change as inflation data has disappointed to the downside in recent months. Nonetheless, this wouldn’t be the first time that removal of monetary policy stimulus preceded a recession.
Exhibit 1: US Treasury forward yield curves have been flattening recently, this is typically a sign of waning confidence in the economic outlook and of heightened recession risk (the graph shows the current US Treasury yield curve and those for 3 and 5 years forward).Source: Bloomberg, as of 17/05/17
Where will normalization of the Fed's balance sheet lead interest rates?
Recent comments from Fed officials imply that the committee is keen to address the size of the balance sheet in the coming year. Fed balance sheet normalization presents new and interesting challenges for the Federal Open Market Committee (FOMC). With little data to draw on, the Fed is increasingly reliant on academic exercises to predict the market’s reaction to a reduction in balance sheet reinvestment. The US Treasury will need to increase Treasury issuance following a Fed balance sheet taper as the US Treasury seeks to offset the funding gap. The market reaction to the increase in issuance will depend largely on how the US Treasury chooses to fund the shortfall. An extension of the average maturity of the Treasury market is largely seen as leading to higher interest rates and steeper yield curves.
Conclusion: The ebb and flow of these themes will likely dominate markets in the medium term.
Continued chaos in the White House will, at best, slow the pace of legislation and depress sentiment sending yields lower as the yield curve bull-flattens and the reflation trade falters. The Fed would likely respond by slowing the pace of normalization and delaying balance sheet adjustments. Conversely, an improvement in the political climate would have the reverse effect. My bet is on “Continued Chaos”, it is horse racing season after all…
Written on 22 May 2017