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A less-hawkish interpretation of the December FOMC
Fed Chair Yellen’s seemingly more-hawkish-than-expected comments at the December FOMC press conference induced a wave of duration shedding as investors priced-in an even less gradual rate path and sent dollar soaring to new heights. Following the well-anticipated 25 bps rate hike, market participants were caught off guard by the Fed Chair’s apparent backpedal from her “high pressure economy” comments, as well as her assessment that fiscal policy “is not obviously needed to provide stimulus” in the context of meeting Fed’s maximum employment mandate.
The Kekselias model portfolio added duration in 7 year part of the curve following the release of FOMC statement and SEP, and the portfolio is 150 DV01 long in belly of the curve with a 210 DV01 5s20s curve steepener. The decision to maintain steepener and to add duration came in response to the following considerations:
- Chair Yellen likely did not intend to send a hawkish signal with her press conference comments
- An aggressive rate path runs against post-election assessments by Governor Powell and President Dudley
- Post-election risk asset strength is vulnerable to retracement as fiscal outlook remain uncertain
- Dollar strength will likely exacerbate pressure on EM currencies and weigh on U.S. economic conditions
Together with the expected 25 bps rate hike, the December FOMC SEP highlighted the following changes:
- SEP “dots” revised higher
- Median “dots” for year-end 2017 at 1.375% vs. 1.125% prior (25 bps, although four of the six lower “dots” remained in the 1.125% range)
- Median “dots” for year-end 2018 at 2.125% vs. 1.875% prior (25 bps)
- Median “dots” for year-end 2019 at 2.875% vs. 2.625% prior (25 bps)
- Long-run funds rate at 3% vs. 2.875% prior
- Chair Yellen described the overall economic projection as “very similar to those made in September. GDP growth is a touch stronger. The unemployment rate is a shade lower. And inflation beyond this year is unchanged.”
Nevertheless, the crucial exchanges took place during Chair Yellen’s press conference Q&A. Investors were surprised by changing narratives on the fiscal stimulus’ evolving roles, as well as Chair Yellen’s assessment on whether she favors running a “high pressure economy.”
Fiscal stimulus “not obviously needed”
When questioned about the economy’s capacity for fiscal stimulus, Chair Yellen commented that both her and former Fed Chair Bernanke called for fiscal stimulus when the unemployment rate was “substantially higher” than present level, and “at this point that fiscal policy is not obviously needed to provide stimulus to help us get back to full employment.”
Markets quickly interpreted this as a hawkish signal, for the Fed must be even closer to objective than expected, that a boost from fiscal stimulus is no longer needed. However, does this suggest a policy shift since the September FOMC? Given the mentioning of Bernanke, this makes sense under a 2014 vs. 2016 context, and it would be too drastic of a change if the Fed saw the need for fiscal stimulus in September, but considered otherwise in December.
If this is not a recent change of policy stance, one would argue that the Fed was comfortable with market expectations following the September and November FOMC (as well as the post-election rates sell-off), and the need for fiscal stimulus had diminished well before recent months, or even perhaps pre-2016.
Additionally, assuming Chair Yellen’s comments represent consensus view, then New York Fed President Dudley’s December 5th comment that the modest post-election FCI tightening seem “broadly appropriate” (if fiscal stimulus are realized) would imply approval on the steepening of rate path that preceded the policy meeting. Combining this with President Dudley’s speech on automatic fiscal stabilizer, it would suggest that the Fed had already given a signal that an automatic stabilizer is more preferable to an outright stimulus program. Indeed, Chair Yellen had the following question during the September FOMC press conference (it was the only discussion on fiscal policy, for fiscal stimulus was not on the minds of market participants pre-election):
Sam Fleming: You did raise the question of automatic stabilizers in the U.S., however. Are you concerned that there is insufficient fiscal backup to the Fed, and too much is effectively being lumped on the shoulders of the central bank if there is a fresh downturn? Thanks.
Chair Yellen: Now, I think it would be—it would be worthwhile for other policymakers to think about what role they could play in addressing negative shocks should they come. And I mentioned specifically automatic stabilizers because I think that’s an important way in which fiscal policy serves to cushion shocks to the economy. And it would seem to me, without getting into specifics, that there are ways in which the response of fiscal policy to shifts in the economy could be strengthened, which would help take some burden off monetary policy.
The aforementioned analysis would raise the question whether markets had sold off twice (post-election and post-FOMC) on the same catalyst. Furthermore, the timing and composition of the fiscal stimulus remain highly uncertain.
The following chart illustrates Jan 2018 Fed funds futures (in rates) and its two-step rise from below 80 bps to finish at 122.5 bps post-FOMC:
Chair Yellen and a “high pressure economy”
The second hawkish surprise came as a reporter referred to Chair Yellen’s speech on running what she termed a high pressure economy. Yellen responded that: “I never said that I favor running a high pressure economy,” and that the speech was to focus on an important research question.
Nevertheless, Yellen followed by saying that the unemployment rate in the SEP is “projected to modestly undershoot for several years levels that are deemed to be normal in the longer run.” She called it an “appropriate policy” given that inflation is running below objective. She added that this policy does involve attracting more people off the sidelines into the labor market. It can be interpreted as an economy running “hot,” albeit not “high pressure.”
This raised the question: did Yellen merely dispute the specific research topic of “high pressure economy” but didn’t dispute the FOMC’s “moderately accommodative” policy with gradual rate path (which markets previously referred to as “high pressure economy”)?
Again, Fed policymakers did not voice concerns over financial conditions and market expectations prior to the November FOMC, and markets should not re-price Yellen’s policy stance on nomenclature rather than established pattern.
Risk management considerations
Governor Powell’s comments on Fed’s risk management considerations with rates within 150 bps of ZLB. If the Fed hikes rates 3 times in 2017 (vs. every meeting during Greenspan’s hiking cycle, which was considered “not gradual”), it would arrive at 150 bps by year-end. This would nullify the purpose of risk management and indicate a major policy shift at the Board of Governors… between November 30th and December 14th. This is not an impossible scenario, but it would be inconsistent.
A near-term “tapering” of risk asset exuberance
Financial markets wasted little time to price-in aggressive fiscal stimulus under a Trump administration and Republican-controlled Congress following the election, and subsequent weakness in belly of the Treasury curve reflected rising expectations of Federal Reserve policy tightening in 2017 and beyond (before another bout of weakness post-FOMC).
Nevertheless, optimistic growth scenarios demand swift policy changes by the incoming administration amid subdued political uncertainty; however, partisan wounds remained flesh, and rancor between establishment politicians and populist insurgents persisted despite the end of a contentious election. To some market participants, current political climate is reminiscent of post-Brexit U.K., where “Remain” and “Leave” campaigners skirmish over terms of Brexit with surprising vigor more than six months following the referendum.
A scenario of prolonged U.S. political uncertainty, pledges of higher fiscal expenditure (albeit with varying efficacy from the perspective of Fed policymakers), and waning appetite for ultra-accommodative policies suggest the following market response:
- Front-end and belly of the Treasury curve to strengthen as markets realign expectations with Fed policy stance
- Long-end of the curve to seesaw but remain largely unchanged
- Higher fiscal deficit and a rise in long-maturity Treasury issuance to weigh on bond valuation
- Less-optimistic growth expectation to diminish risk sentiment and compress long-end term premium
- ECB’s cautious “non-taper” QE reduction and BOJ’s Yield Curve Control to signal waning policy support toward “stimulus via term premium compression”
- Renewed dollar strength to pressure risk assets (which rallied considerably post-election), high yield spreads, commodities and EM currencies The PBOC’s USDCNY fixing was adjusted to 6.9349 post-FOMC
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