Uncategorized

Lowering the longer run view of rates

| 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

Source: Federal Reserve, Amherst Pierpont Securities

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.

* * *

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.

admin
jkillian@apsec.com
john.killian@santander.us 1 (646) 776-7714

This material is intended only for institutional investors and does not carry all of the independence and disclosure standards of retail debt research reports. In the preparation of this material, the author may have consulted or otherwise discussed the matters referenced herein with one or more of SCM’s trading desks, any of which may have accumulated or otherwise taken a position, long or short, in any of the financial instruments discussed in or related to this material. Further, SCM may act as a market maker or principal dealer and may have proprietary interests that differ or conflict with the recipient hereof, in connection with any financial instrument discussed in or related to this material.

This message, including any attachments or links contained herein, is subject to important disclaimers, conditions, and disclosures regarding Electronic Communications, which you can find at https://portfolio-strategy.apsec.com/sancap-disclaimers-and-disclosures.

Important Disclaimers

Copyright © 2023 Santander US Capital Markets LLC and its affiliates (“SCM”). All rights reserved. SCM is a member of FINRA and SIPC. This material is intended for limited distribution to institutions only and is not publicly available. Any unauthorized use or disclosure is prohibited.

In making this material available, SCM (i) is not providing any advice to the recipient, including, without limitation, any advice as to investment, legal, accounting, tax and financial matters, (ii) is not acting as an advisor or fiduciary in respect of the recipient, (iii) is not making any predictions or projections and (iv) intends that any recipient to which SCM has provided this material is an “institutional investor” (as defined under applicable law and regulation, including FINRA Rule 4512 and that this material will not be disseminated, in whole or part, to any third party by the recipient.

The author of this material is an economist, desk strategist or trader. In the preparation of this material, the author may have consulted or otherwise discussed the matters referenced herein with one or more of SCM’s trading desks, any of which may have accumulated or otherwise taken a position, long or short, in any of the financial instruments discussed in or related to this material. Further, SCM or any of its affiliates may act as a market maker or principal dealer and may have proprietary interests that differ or conflict with the recipient hereof, in connection with any financial instrument discussed in or related to this material.

This material (i) has been prepared for information purposes only and does not constitute a solicitation or an offer to buy or sell any securities, related investments or other financial instruments, (ii) is neither research, a “research report” as commonly understood under the securities laws and regulations promulgated thereunder nor the product of a research department, (iii) or parts thereof may have been obtained from various sources, the reliability of which has not been verified and cannot be guaranteed by SCM, (iv) should not be reproduced or disclosed to any other person, without SCM’s prior consent and (v) is not intended for distribution in any jurisdiction in which its distribution would be prohibited.

In connection with this material, SCM (i) makes no representation or warranties as to the appropriateness or reliance for use in any transaction or as to the permissibility or legality of any financial instrument in any jurisdiction, (ii) believes the information in this material to be reliable, has not independently verified such information and makes no representation, express or implied, with regard to the accuracy or completeness of such information, (iii) accepts no responsibility or liability as to any reliance placed, or investment decision made, on the basis of such information by the recipient and (iv) does not undertake, and disclaims any duty to undertake, to update or to revise the information contained in this material.

Unless otherwise stated, the views, opinions, forecasts, valuations, or estimates contained in this material are those solely of the author, as of the date of publication of this material, and are subject to change without notice. The recipient of this material should make an independent evaluation of this information and make such other investigations as the recipient considers necessary (including obtaining independent financial advice), before transacting in any financial market or instrument discussed in or related to this material.

The Library

Search Articles