In a 1955 speech, William McChesney Martin, the longest-serving chairman of the Federal Reserve, memorably described his institution as “the chaperone who orders the punch bowl removed just when the party is really warming up.”
It’s clear from the now famous “dot plot” that some members of the Federal Open Market Committee (FOMC) think that the party is warm enough to remove the punch bowl next year by pushing rates up to 2.25 per cent or more. However, after converging with those dots toward the end of last year and into early 2017, the market’s expectation for rate hikes has diverged, erring on the side of a slower upward trend.
We think the market is right. To understand why, we need to understand inverted yield curves, hear the nuances in what was possibly Janet Yellen’s final testimony before Congress last week, and remember that the Fed doesn’t have to raise rates to tighten monetary conditions.
Eye on the yield curve
Typically, the average level of the 10-year yield in the year or so before the end of a business cycle has foreshadowed where short rates end up. What happens is that the longer end of the curve anticipates the turn in the cycle, and the end to restrictive monetary policy as short rates are pushed through their so-called “neutral” rate, where they act to slow down growth and inflation and thereby turn the cycle. That’s why an inverted yield curve has come to be a pretty reliable indicator of an imminent end to a cyclical expansion.
But it’s also true that financial market indicators such as these are partly causes, as well as symptoms, of dynamics in the real economy. Investors and business people are conditioned to know what an inverted yield curve means, and a natural cautiousness creeps into their decision-making: They become less likely to invest aggressively or hire employees. It’s what George Soros described as “reflexivity” in his 1987 book, ‘The Alchemy of Finance’, and it’s why the Fed will likely do everything in its power to avoid an inverted yield curve as it navigates its way back to policy normalisation.
Short end of the curve
Last week, with words like “gradual,” “persistent” and “long-term,” Yellen signalled to us that, notwithstanding the dot plot, the Fed would remain focused on normalisation rather than short-term fluctuations in economic data, and that normalisation might be a years-long project.
She also confirmed her thinking that the long-run neutral rate of interest — that which is “neither expansionary nor contractionary if the economy were operating near its potential,” as the Fed itself puts it — continues to be low, and possibly lower than its work published at the end of last year suggests, relative to its history. The path back to normalisation will likely be very gradual, then, as well as very long.
Yellen’s words were taken as a dovish turn compared with recent pronouncements, and they did flatten the yield curve by shaving a few points off the long end. But, more importantly, they should serve to anchor the short end and lessen the risk of inversion.
Watering down the punch
Moreover, the market understands that the Fed doesn’t have to hike rates in order to tighten monetary conditions. Starting out with a multi-trillion dollar balance sheet, it can achieve just as much, if not more, simply by allowing its asset purchases to run off. As this run-off kicks off later this year, the inevitable effect on the yield curve will ultimately be to steepen it. Our general view remains that the Fed will not engage, over the near term, in a process that includes both hiking rates and aggressively unwinding its balance sheet simultaneously.
The punch bowl is likely here to stay, then, in the shape of low and gradually climbing rates. But the punch inside it, the loose monetary conditions that have kept the economy ticking over and inflated financial asset prices? That’s likely to be slowly and imperceptibly watered down. The hope is that we all get to leave this unusually long cycle with a good party buzz despite being surprisingly sober — and with no need for sore heads or drunken tantrums.
— Brad Tank is the Chief Investment Officer, and Global Head of Fixed Income at Neuberger Berman.
