Tightening Finally On The Horizon
BMI View: The Federal Reserve will begin paring back asset purchases by the end of 2013, and end them altogether by end-2014, but will hold off on raising the benchmark funds rate until 2015. At this point, market expectations of near-term rate hikes are overblown, but the long-term uptrend in long-end yields is clearly in place. We have raised our end-2015 Fed funds rate forecast to 0.75% from 0.50%, and to 2.00% from 1.50% for end-2016.
Despite recent volatility in rates markets, as uncertainty increases over the timeline for the Federal Reserve (Fed) ending monetary stimulus, our core views on US monetary policy are unchanged. We still believe that the Fed will begin 'tapering' asset purchases by the end of 2013, while stopping the expansion of its balance sheet by mid-2014. Furthermore, despite increasing market expectations for a rate hike in 2014, we still believe that the Fed will hold off until 2015, as its guidance had previously suggested.
The post-June 18-19 Federal Open Market Committee (FOMC) meeting statement (see below) indicates clearly that the FOMC expects to begin tapering QE3 later in 2013, with the US$85bn in monthly purchases being reduced (perhaps to US$50bn or so initially). Chairman Ben Bernanke said that if the FOMC's economic forecast plays out, then quantitative easing purchases will be ended outright by mid-2014, with no further expansion of the Fed balance sheet. Both of these expectations are in line with our view that the reduction in the pace of purchases would begin in Q413, while the end of QE would occur in H114. Furthermore, the 'Evans Rule' - under which the Fed has said it will keep rates at near-zero levels 'at least as long as' as the unemployment rate remains above 6.5% and the one-to-two-year inflation outlook remains below 2.5% - suggests that the next Fed funds hike is due in 2015.
|Source: Federal Reserve, BMI|
|QE3 Tapering Set To End By Late 2013; Purchases To End Completely In Mid-2014||"If the incoming data are broadly consistent with [the FOMC] forecast, the Committee currently anticipates that it would be appropriate to moderate the monthly pace of purchases later this year; and if the subsequent data remain broadly aligned with our current expectations for the economy, we would continue to reduce the pace of purchases in measured steps through the first half of next year, ending purchases around midyear." -FOMC Minutes|
|Downside Risks Are Falling||"The Committee sees the downside risks to the outlook for the economy and the labor market as having diminished since the fall." - FOMC Minutes|
|QE3 Will End When Unemployment Is Around 7%||"...when asset purchases ultimately come to an end, the unemployment rate would likely be in the vicinity of 7%, with solid economic growth supporting further job gains." Bernanke, Post-Meeting Press Conference|
While we expected a pickup in the US economy in H213 to readjust the market's monetary tightening expectations, the recent ructions in bond markets have occurred with a paucity of evidence of a major surge in US economic activity or price pressures (unemployment remains above 7.5%, the most recent ISM manufacturing PMI for May was under 50.0, and core PCE inflation was at an all-time low of 1.06% y-o-y as of May). It is hard to imagine the Federal Reserve and Bernanke withdrawing stimulus with inflation at such low levels and growth still below-trend, particularly as Bernanke has made a career of decrying episodes of monetary policy in which stimulus was withdrawn prematurely.
But the Fed's rhetoric has been changing as it becomes more upbeat on the prospects for US growth and the dissipation of risks to the downside. Its forward guidance is coming into line with BMI's view that the US recovery has found a firm foundation and that expansion will accelerate going into 2014-15. The following table shows the FOMC's latest economic projections, published alongside the June 18-19 meeting, along with its previous set of forecasts made in March. Clearly, the Fed has become increasingly optimistic about economic growth in 2014, and with it, the labour market. Its central tendency for 2014 unemployment is 6.5-6.8%, for example, down from 6.7-7.0% in March, and implying that should the core forecast come to pass, a complete tapering of asset purchases would be warranted.
|Source: Federal Reserve|
|Change in real GDP||2.3 to 2.6||3.0 to 3.5||2.9 to 3.6||2.3 to 2.5|
|March projection||2.3 to 2.8||2.9 to 3.4||2.9 to 3.7||2.3 to 2.5|
|Unemployment rate||7.2 to 7.3||6.5 to 6.8||5.8 to 6.2||5.2 to 6.0|
|March projection||7.3 to 7.5||6.7 to 7.0||6.0 to 6.5||5.2 to 6.0|
|PCE inflation||0.8 to 1.2||1.4 to 2.0||1.6 to 2.0||2.0|
|March projection||1.3 to 1.7||1.5 to 2.0||1.7 to 2.0||2.0|
|Core PCE inflation||1.2 to 1.3||1.5 to 1.8||1.7 to 2.0|
|March projection||1.5 to 1.6||1.7 to 2.0||1.8 to 2.1|
Looking at the chart of the trajectory of the unemployment rate below , with a simple extrapolation, it is fairly easy to see how the FOMC comes to the conclusion that it will end bond purchases by mid-2014 and begin hiking the funds rate sometime in 2015. For our part, we project that the unemployment rate will only drop below 6.5% in late 2015, assuming the rate of monthly nonfarm job creation of around 170,000 remains roughly in place (which is consistent with our average growth projection of 2.6-2.7% in 2014 and 2015) . Even assuming a decent uptick to 200,000 monthly, the 6.5% unemployment threshold would not be reached before 2015.
|US - Unemployment Rate (%)|
But even though tightening is finally on the horizon, it is important to keep in mind that the Fed has not yet begun to tighten policy - and quite the opposite, as it is still purchasing US$85bn in mortgage-backed securities and long-dated Treasuries every month until further notice. This is the equivalent of US$5bn being purchased on a daily basis, and while this is not making its way into credit markets, it is still significant. Furthermore, the FOMC retains the flexibility to continue purchases should the growth outlook deteriorate, for example if there is an external shock. With this in mind, incoming economic data will become increasingly crucial. Any sign that the unemployment rate in particular is at risk of straying from its downward trajectory would throw the Fed's plans into doubt.
Although US Treasuries are oversold on a short-term basis, and could rally slightly - particularly at the short end of the curve - we believe the long-term trend of higher yields is in place. We had o riginally argued that the US 10-y ear Treasury yield had bottomed out in September 2012 following the announcement of QE3, underpinned by our view that the US recovery would gain strength as 2013 proceeded. But the magnitude of the recent move has taken us somewhat by surprise, given our previously-held view that it would trade between the 1.6-2.3% range for most of 2013. We still believe that the uptrend will remain in place over the coming quarters, and believe that we are likely to see the 10- year note trading around or above the 2.5% mark by year-end. Beyond the 2.75% level, which is crucial in determining medium-term direction, the next target on the upside would be 3.50%. There is a major trendline that comes in at around 4.00%. A move through that level would confirm that the 30-year secular bull market in bonds has come to an end. We are a long way off that point, but it is worth keeping in mind as the US recovery proceeds .
|Real Yields In Positive Territory|
|US - 10-Year Treasury Inflation Protected Security Yield (%)|
With inflation coming down, real US yields are rising. The US 10-year TIPS breakevens yield chart above shows a move above 0.00% (in other words, positive real yields, with 10-year UST yields above expected inflation) for the first time since late 2011. For the Fed and Bernanke, this move either means 'mission accomplished' in the sense that economic activity is picking up and the market is increasingly comfortable with the growth outlook, or 'danger ahead' as higher real yields could choke off the nascent recovery. Already, mortgage rates are rising rapidly, with the 30-year fixed mortgage rate above 4.5%, up from under 3.5% at the beginning of May. While the demand for housing is likely to remain robust even at slightly higher financing rates, the Fed is likely to tread cautiously, as its QE programme was intended in part to help heal the housing market. Low interest rates are not necessarily stimulative if they are above the rate of inflation, though in this case, housing inflation is running at over 12% y-o-y, according to the Case-Shiller index . Bernanke and the rest of the FOMC appear to believe that the low inflation rate is transitory in any case, with the core PCE inflation index rising from a central tendency of 1.2-1.3% in 2013 to 1.5-1.8% in 2014. This seems reasonable to us, given that part of the reason for falling inflation this year is the sharp drop in global commodity prices and the muted year-on-year contribution of energy costs directly impacting headline CPI as well as feeding into core prices.
In the wake of the June 18-19 FOMC meeting, the market priced in as much as 125bps in rate hikes by the end of 2015, as well as at least one hike by the end of 2014. We believe that the se fears are misplaced, as the Fed is very much unlikely to raise short-end rates until it reaches its unemployment 'target' of 6.5% or lower, and until it has begun to allow assets to begin rolling off its balance sheet . Of the 19 FOMC participants at the June 18-19 meeting , 14 envisaged the first funds rate increase in 2015, with one suggesting 2013, three naming 2014, and one projecting 2016. While these are not binding commitments, they are in line with the Fed's previous pronouncements and the most likely scenario given the economic trajectory. We have increased our forecast for the funds rate by end-2015 to 0.75% from 0.50%, rising to 2.00% by the end of 2016, with risks to the upside.
Finally, it is worth acknowledging that Bernanke's term as Fed chairman expires in January 2014, and many expect that he will be replaced by the current Vice Chairman of Fed, Janet Yellen. Yellen is perceived by many as having a dovish bias, especially regarding the Fed's multiple quantitative easing efforts, a bias that may make confirmation hearings in the US Senate difficult. If confirmed, we expect that Yellen would likely oversee a continuation of many of the policies in place, including the plan to normalize monetary policy in line with improvements in the broader economy.
|Pricing In A More Aggressive Fed|
|US - Implied Rate Hikes By End Of 2015 (From Eurodollar Futures Market)|
Risks To Outlook