In recent months, many investors have greatly reduced the odds of the Federal Open Market Committee (FOMC) maintaining a steady dose of policy rate increases over the medium term. By the end of April, the combination of disappointing first quarter data, a foundering global growth environment, and a very cautious March speech from FOMC Chair Yellen all contributed to markets discounting just one or two rate increases by the end of 2017 – a far cry from the 150 basis points of policy tightening projected in the FOMC’s policy rate “dot plot” released after the March meeting.
Against this backdrop the minutes from the FOMC’s April meeting, released on 18 May, caught most investors by surprise. The minutes revealed that as a whole, the Committee maintains a high degree of confidence in its projections for moderate growth and gradually firming inflation. In addition, low inflation expectations and downside risks from abroad – key elements from Yellen’s March speech that led investors to discount a flatter trajectory for the policy rate – appeared to play little role in the meeting deliberations. And perhaps most importantly, the FOMC appears to have a relatively low bar for a June rate increase: at the time of the meeting, “most” participants viewed such a move as appropriate should incoming data prove consistent with “growth picking up in the second quarter, labor market conditions continuing to strengthen, and inflation making progress toward the Committee’s two percent objective.”
Does the prospect of a rate hike raise the risk of a taper tantrum?
In the wake of the minutes release, a range of assets repriced to reflect higher odds of a June rate increase. The dollar appreciated against a range of currencies, global equities declined, and Treasury yields rose. The rise in longer-term yields has led to market discussion that should a June rate increase come about, long-term rates could rise sharply in a replay of the 2013 “taper tantrum”. However, our view is that under current economic conditions, a large rate shock is highly unlikely.
Exhibit 1: 10-year Treasury yield decomposition
Source: Federal Reserve Bank of New York. Note: Shading denotes 2013 Taper Tantrum
First of all, terminology matters. The taper tantrum was not simply a repricing of long-term rates due to perceptions of a hawkish FOMC. More accurately, the taper tantrum stemmed from a pronounced reduction in average market expectations for the amount of assets the Federal Reserve would ultimately purchase in its quantitative easing (QE) program. As such, and as seen in the shaded section of the chart, the taper tantrum led to a sharp increase in the term premium component of the 10-year nominal Treasury yield. The drift higher in the average expected short-term rate (the so-called risk-neutral yield) early in the taper tantrum was entirely modest by comparison.
The term premium is stretched but we see no reason for an imminent rise…
The term premium is currently estimated to be well below zero and at a very stretched level even by the standards of the post-crisis period. Effectively, investors are paying to take on the risks associated with owning a long-term instrument that pays a fixed nominal return. As we have noted previously, one of the factors suppressing the term premium is the expectation that central banks globally will continue to rely on a range of unconventional measures, including QE, to stimulate growth. We see little reason for this expectation to shift meaningfully – both the European Central Bank and the Bank of Japan are continuing with their QE programs, and investors generally expect that both central banks will ultimately need to increase the amount of purchases beyond what has been announced this far. Second, a very low (and also likely negative) inflation risk premium has contributed to the low level of the term premium.
With the Committee signaling its comfort with raising rates while inflation remains short of the 2% objective and with investors concerned that rate increases could prompt a new round of disinflationary dollar strength, this component of the term premium is unlikely to rise either. Finally, while elevated economic and political uncertainty could lead to a higher term premium in the months ahead, the associated “risk-off” sentiment would push the term premium in the opposite direction.
The Fed is talking the talk but the market isn’t pricing it walking the walk…
So if there are good reasons why the term premium may remain near multi-year lows, what are the prospects that the risk-neutral yield component of the 10-year Treasury yield will move higher? On the one hand, the FOMC’s confidence in its economic outlook – and by implication, its projections for higher policy rates – implies that markets may be fundamentally mispricing the average policy rate over the next ten years. However, we do not subscribe to this view. The Committee remains stuck in a negative feedback loop with markets. Many investors still see somewhat elevated recession risks over the medium term, and are concerned that a higher policy rate will lead to unduly restrictive financial conditions that will choke off growth, particularly given the potential for renewed dollar appreciation should Federal Reserve policy diverge from the policy stance of other major central banks. In addition, any attempt to sustain even gradual policy rate increases could put renewed pressure on Chinese officials to devalue the yuan against the dollar, an outcome which could again increase downside risks to US growth. Investors also remain concerned that the waning of current stimulus in China will provide a headwind to global growth and the recovery in commodity prices in the second half of the year. Finally, even if moderate growth can be sustained as the FOMC raises rates, the expected rate path may remain anchored at relatively low levels given that investors have a much lower estimate of the longer-run equilibrium federal funds rate than the Committee.
The sobering reality for the FOMC is that markets will continue to attach little credibility to the median rate path expressed in the Committee’s economic projections so long as inflation remains low and the Committee continues to act as if it has little tolerance for above-objective inflation. This, along with continued low levels of the term premium, will likely prevent a significant repricing of longer-term yields for the time being.
This article was written on 24 May 2016 in New York.