Yellen Takes The Reins

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by: Neuberger Berman

By Brad Tank, Chief Investment Officer - Fixed Income

The Fed has a wide open backstretch to get in front of the market.

Since the Federal Reserve's move to taper quantitative easing in 2013 (and subsequent market turbulence known as the taper tantrum), we've seen a consistent theme in monetary policy: The Fed has generally overestimated growth and inflation, and as a consequence, its projections on policy rates. In fact, the market has consistently done a better job of forecasting inflation and policy than the Fed, creating a persistent gap in expectations.

My colleagues and I have reflected on this trend since the early days of CIO Weekly Perspectives (see "The Fed Sticks to the Script," July 31, 2016 ). But importantly, what we've seen over the past six months, punctuated by the Fed's 25-basis-point move in December, is a convergence of forecasts from the bond market and the Fed. To wit, the FOMC now anticipates three rate hikes in 2017, while the market expects somewhere between two and three, depending on the date of measurement.

To see why, it helps to understand that the Fed's forecasting and modeling were confounded for some time by certain themes that we've written about. That is, persistently weak productivity and unusual patterns in the labor market - specifically the rapid decline of the workforce participation rate despite an improving economy. The combination dampened growth and inflation in ways the Fed did not anticipate. Multiple global economic strains made matters worse, including the deceleration in emerging markets, the commodity price collapse and sluggishness and uncertainty in Europe. All triggered caution lights that kept monetary tightening from gaining steam.

The Field Has Opened Up

However, we're in a different environment now. Pushing aside the current political turbulence, economic activity is gaining momentum, consumers are more confident and equity markets are up, while inflation is showing moderate acceleration. Encouragingly, the labor force stagnation that hampered the Fed so much is showing signs dissipating, although productivity remains a long-term challenge.

The net effect is an inflection point for monetary policy, both in terms of perception and substance.

Over the past few years, the Fed has largely been a market follower, and very careful as to the information it conveyed to investors. The notion was to avoid doing harm to the markets or to a fragile economy. But a "stay out of the way and don't make trouble" approach can only take you so far. And we warned repeatedly that the Fed would at some point need to be more assertive in its communications and actions - lest events become even more difficult to influence.

Will the Fed Actually Lead?

As I write today, the Fed has an opportunity to move into a position of leadership vis-à-vis the markets for the first time since the end of quantitative easing. Fortunately, that appears to be happening, as reflected in the upward shift of policy expectations in December, Yellen's more hawkish recent speeches and the "sooner is better than later" minutes from the FOMC's January meeting. We're not talking about anything dramatic, but there appears to be a trend.

Looking ahead, the Fed has seven more meetings this year in which to make good on its expectation of three additional rate increases. At this point, the market is discounting just a 22% chance of an upward move in March, and debating whether May or June is a more realistic timeframe. Without opining about a specific meeting, we think the Fed could be a bit more aggressive than advertised - with at least three but possibly four rate increases on tap this year.

How will the market take it? Pretty well, we think. The gains in risky assets, this year's retreat in the dollar (after a nice run in 2016) and the persistent rise of inflation since mid-2016 reflect a market with some resilience - affording the Fed a level of freedom it hasn't had for some time.

Naysayers argue that the Fed's preferred inflation measure (the Personal Consumption Expenditure index, or PCE) is still 40 basis points below its target. But, in our view, they are missing the point. Given where we are in the business cycle and against the backdrop of increasing inflation, short-term rates are still artificially low, something the Fed is acutely aware of, but tends not to emphasize.

In Case You Missed It

  • U.S. Existing Home Sales: +3.3% to SAAR of 5.69 million units in January

  • Eurozone Consumer Price Index: -0.8% in January month over month and +1.8% year over year
  • U.S. New Home Sales: +3.7% to SAAR of 555,000 units in January

What to Watch For

  • Monday 2/27:
    • U.S. Durable Goods Orders
  • Tuesday 2/28:
    • U.S. 4Q16 GDP (second estimate)
    • Case-Shiller Home Prices Index
    • U.S. Consumer Confidence
  • Wednesday 3/1:
    • U.S. Personal Income & Outlays
    • ISM Manufacturing Index
  • Friday 3/3:
    • ISM Non-Manufacturing Index

- Andrew White, Investment Strategy Group

Statistics on the Current State of the Market - as of February 24, 2017

Market Index WTD MTD YTD
Equity
S&P 500 Index 0.7% 4.1% 6.1%
Russell 1000 Index 0.7% 4.0% 6.1%
Russell 1000 Growth Index 0.7% 4.4% 7.9%
Russell 1000 Value Index 0.6% 3.7% 4.4%
Russell 2000 Index -0.4% 2.5% 2.9%
MSCI World Index 0.3% 2.9% 5.4%
MSCI EAFE Index -0.1% 1.3% 4.2%
MSCI Emerging Markets Index 0.5% 3.8% 9.5%
STOXX Europe 600 -0.5% 0.7% 2.9%
FTSE 100 Index -0.4% 2.8% 2.2%
TOPIX 0.4% 1.9% 2.1%
CSI 300 Index 1.5% 2.5% 4.9%
Fixed Income & Currency
Citigroup 2-Year Treasury Index 0.1% 0.2% 0.3%
Citigroup 10-Year Treasury Index 1.0% 1.1% 1.2%
Bloomberg Barclays Municipal Bond Index 0.6% 0.6% 1.3%
Bloomberg Barclays US Aggregate Bond Index 0.6% 0.9% 1.1%
Bloomberg Barclays Global Aggregate Index 0.6% 0.3% 1.5%
S&P/LSTA U.S. Leveraged Loan 100 Index 0.2% 0.4% 0.7%
BofA Merrill Lynch U.S. High Yield Index 0.6% 1.3% 2.7%
BofA Merrill Lynch Global High Yield Index 0.4% 0.9% 2.8%
JP Morgan EMBI Global Diversified Index 0.7% 1.9% 3.4%
JP Morgan GBI-EM Global Diversified Index 1.0% 2.3% 4.6%
U.S. Dollar per British Pounds 0.5% -0.7% 1.1%
U.S. Dollar per Euro -0.6% -2.2% 0.2%
U.S. Dollar per Japanese Yen 0.4% 0.2% 3.8%
Real & Alternative Assets
Alerian MLP Index -2.1% 0.1% 5.0%
FTSE EPRA/NAREIT North America Index 1.9% 3.7% 3.3%
FTSE EPRA/NAREIT Global Index 1.5% 3.6% 4.7%
Bloomberg Commodity Index -0.7% -0.1% 0.0%
Gold (NYM $/ozt) Continuous Future 1.5% 4.1% 9.3%
Crude Oil (NYM $/bbl) Continuous Future 0.4% 2.2% 0.5%

Source: FactSet, Neuberger Berman

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