The Fed Bets on Growth

Chair Janet Yellen's last FOMC decision was talked into financial markets months, if not years in advance. And the Fed increased its economic forecasts somewhat. But not all market participants - or FOMC members, see the future the same way.

DEC 13 2017

The FOMC's Majority Report

To nearly nobody’s surprise, the Federal Open Market Committee (FOMC) raised its benchmark Fed Funds target rate to 1.50%, a 25 basis point (bps) rise. This is the 5th hike since the Federal Reserve (Fed) began lifting its reference rate at the end of 2015.  

The famously data-dependent central bank certainly has economic facts and figures on its side. November’s unemployment rate was 4.1%, with private-sector payrolls rising by 228k and headline consumer inflation for October hovering near the Fed’s 2% target. In fact, the Fed raised its own forecasts: GDP growth to 2.5% from 2.1% for 2018; to 2.1% from 2% for 2019, and 2% from 1.8% for 2020. 
 

But The Minority grew, and Markets Still Say: "Not So Fast..."

Surprisingly, the two dissenting members of the FOMC, Charles Evans and Neel Kashkari voted against the hike, saying the economy needed more time to gather steam.

Financial markets, also appear to have had a different view so far. Yields on 30-year US Treasuries have fallen nearly 30 bps since the beginning of the year as yields on the shorter end of the curve have risen markedly (1-year Treasury yields are up 86 bps). This flattening of the yield curve is seen by some as a harbinger of stalling growth.

Western Asset Chief Investment Officer Ken Leech compares the US yield curve to Cassandra, a figure from Greek mythology whose predictions were always right, yet never believed - a mistake that investors, such as Western Asset, want to avoid. In  Ken Leech's words: “We take the warning sign of the yield curve at face value.” 

This divergence is mainly due to the lack of inflation and inflationary pressures: while US unemployment has dropped to 4.1%, the lowest since 2001, wage growth is not accelerating and inflation remains relatively subdued. The Fed mostly believes this is a temporary issue, while some investors say this is because of technology developments, which push the price of certain services lower, as well as due to the impact of globalisation. Others blame aging Western societies that save more than spend and others emphasise the decreasing power of unions. 

Whichever the cause, the fact is that inflation has been stubbornly low, anchoring long-maturity Treasuries and ultimately flattening the yield curve, despite the Fed's efforts to ignite future growth.

As Brandywine Global's Jack McIntyre said after Janet Yellen's press conference, "To us, the dot plots are just noise—they are a forecasting tool, when in reality, the Fed will continue to monitor market and economic conditions. Ultimately, Fed policymaking will remain data dependent. 

McIntyre continued, "The March 2018 Federal Open Market Committee meeting will be an important one given the Fed’s impending leadership transition. We do not think Powell will want to “rock the Fed boat” unless something changes dramatically. Therefore, the Fed should be on cruise control for much of 2018 as it just laid out the roadmap for next year at the December meeting. Interestingly, there were two dissenters who were in favor of not hiking rates at the December meeting—which has been a very rare development—so perhaps the Fed should consider taking the March hike off the table for now. "

This is why some asset managers, such as Brandywine Global, see greater opportunity in Emerging Markets, given their growth potential and improving fundamentals.  Click here to read Brandywine Global's "Around the Curve" blog: Emerging Markets: Dangerous? Or Just Like the Rest?

Only time will tell whether a new balance will be struck between the believers in growth and the more skeptical “show-me” participants in bond markets. In times of uncertainty, and as major central banks withdraw their decade-long monetary stimuli, active managers with an unconstrained approach may help investors find the choice that suits them best.

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