By Thanos Bardas, Portfolio Manager, Head of Interest Rates, Global Investment Grade Fixed Income
The Federal Reserve builds momentum for further tightening.
Today's move by the FOMC to hike the Federal funds rate by 25 basis points makes good on recent comments from Janet Yellen and her colleagues that the next policy move would come sooner rather than later. Only a few weeks ago, Fed funds futures reflected about a 25% chance of an increase in March. By this past Monday, that figure had surged to more than 90%, making the actual event a virtual afterthought.
Why the slam-dunk rate hike? And, perhaps more importantly, why now? Clearly, the Fed has been looking to cautiously roll back easy monetary policy and abnormally low rates for some time, only to be foiled repeatedly by a tepid economy and exogenous events - China weakness and Brexit to name two examples from 2016 (although whether they should have been so easily discouraged is another question).
The central bank finally got its opportunity for renewed tightening in December, at which point, the Fed's attitude appeared to be "we're done for now," with the next likely hike as far away as June, as reflected in the Fed dots (FOMC member estimates of fed funds levels in the coming quarters) and market levels.
But that was before relatively weak job creation, excess inventories and business uncertainty gave way to an array of strengthening data: so-called soft releases-PMI, small business and consumer confidence surveys - as well as harder data on payrolls and employment, coupled with firming inflation. As an example, jobs were created at a rate of 148,000 per month during the fourth quarter of 2016 versus 237,000 year to date in 2017, resulting in a more confident FOMC. Euphoria around the economic strengthening contributed to buoyant credit and equity markets (Dow 22,000, anyone?), helping seal the deal for the Fed.
In terms of FOMC views, changes in the Fed dots for the meeting were very gradual. With virtually no change in the median view for 2017 (two more hikes) and 2018 (three hikes), there were modest increases (less than 15 bps) in all other statistical measures such as mean and trimmed mean. The stock and bond markets both reacted with a relief rally.
Getting Started, While They Can
What's next? In her speech on Friday, March 3, Yellen appeared to lay out her response function for the coming cycle. If the real fed funds rate remains very negative (below minus 1%), near-term equilibrium short rates should be close to zero - requiring four rate hikes (starting with today's) over the next 12 months. A second, longer-term leg of the strategy would bring real rates from zero to 1%. That phase could involve not just rate increases, but a potential reduction of the fed balance sheet. We should know more by the September meeting, when hopefully there will be more clarity on tax reform.
Circling back to the "why now" question, assuming that the Fed was itching to raise rates three or four times in the coming year, it probably became important to get the ball rolling this month and avoid having to backload increases late in the cycle. Call me crazy, but politics could also have been a factor. The title of this column references France's "On the Move!" party, led by the fresh-faced Emmanuel Macron. Only time will tell how his eclectic liberal approach will fare against Marine Le Pen, François Fillon and other rivals, but the point here is that the various European elections and ongoing divisive issues threaten to create periodic crisis environments that could force the Fed to pause its rate plans - again, providing motivation to get moving on rate increases.
And while we're at it, let's talk about job security - specifically Janet Yellen's. If the Fed chair believes she'll be taking an extended vacation after January 2018 when her term expires, perhaps today's move and others to follow could allow for autopilot policy while a transition takes place, or for some preemptive dampening of economic froth tied to fiscal policy. A parting shot, shall we say?
En marche, Fed!
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