Lowering the longer run view of rates
admin | June 21, 2019
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.
Regardless of where fed funds go over the next few weeks or months, one of the more remarkable results of the June FOMC meeting was the revision in the expected longer run level of fed funds from 2.8% to 2.5%. This might seem minor, but it signals the committee’s collective wisdom about the rate that compensates investors in the long run for inflation and the real cost of money. It implicitly reflects the Fed’s view of longer rates, which seems to be that 2.5% represents the right neighborhood for fair value in 10-year and longer rates. Given current pricing, however, the market has its doubts.
The median longer run fed fund rate expected by the FOMC since late 2017 had ranged between 2.8% and 3.0% with occasional changes from one quarter to the next of 0.1% to 0.2% (Exhibit 1). That made the latest change of 0.3% notable.
Exhibit 1: A sharp drop in June for FOMC longer run fed funds expectations
If the Fed is committed to 2% inflation—and Powell noted in his prepared press conference remarks after the June FOMC that the Fed remained “firmly committed”—then the drop in longer run Fed funds has to reflect lower expectations for real rates. Real rates measure the balance between the supply and demand for money, so either the Fed expects a lot more money to be sloshing around the economy or for demand to drop.
The Fed in June did not drop its estimate of longer run economic growth, which remained at 1.8%, so an expected drop in demand for money seems unlikely. Low potential growth has been the orthodoxy for several years. Expected annual labor force growth of 0.5% and productivity growth of 1.25% presumably underpins that expectation. That certainly is the reasoning that led the San Francisco Fed to estimate longer run potential growth of 1.5% to 1.75% a few years ago.
The drop in expectations for longer run fed funds, for now, remains a bit of a mystery. The Fed is offering no indication of falling expectations for potential growth, and its commitment to controlling inflation expectations suggests no expected rise in the supply of money. We’ll have to wait to find out more.
From a practical standpoint, the new lower level for long run funds creates an important line for the Fed. Rates above that level presumably dampen inflation, and rates below presumably give inflation a lift. As has been noted recently, a continuing run of inflation expectations below the Fed’s target should prompt the Fed to drop rates below this line of neutrality.
The market continues to aggressively price Fed cuts through next year and 10-year rates just above 2.0%. If the Fed delivers on market expectations and convinces the market of Fed ability to navigate the vagaries of the effective lower bound on interest rates, 10-year and longer rates should head towards 2.5%. To the extent they price lower, the market arguably is expressing doubt about either the Fed’s path, its ability to navigate the effective lower bound or both. It is clearly a challenging time for the Fed.
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The view in rates
Despite several weeks of some of the year’s highest realized volatility in US 10-year yields, they continue to bounce sideways between 2.0% and 2.1%. The June FOMC did not change that, so the market moves on to the G20 on June 28-29. Look for volatility to continue with some temporary respite after the G20. Fundamental fair value for 10-year rates remains around 2.50%, but uncertainty around tariffs and their impact and the timing and magnitude of Fed action should keep rates from getting there.
The view in spreads
Market expectations for Fed rate cuts should help spreads, especially in credit. Credit markets increasingly reflect confidence that the Fed will act to counter any economic weakness that would normally trigger weaker credit fundamentals and wider spreads. Market volatility should counteract some of the optimism.
The view in credit
Corporate credit on the margin looks like it is improving from its state last year. Various measures of leverage paint a mixed picture, but many are improving. Companies have started to divert cash flow toward paying down debt, have started to sell non-core assets and have curtailed stock buybacks. Management has heard the concerns of debt investors. As Stephen Stanley points out this week, households continue to look strong with low unemployment, rising home prices, and generally good performance in investment portfolios.