While there has been a bevy of political headlines in recent weeks related to future policies from the new administration, the markets have largely taken everything in stride, with the Dow Jones Industrial Average breaching the 20,000 mark for the first time ever. Fixed-income markets have held relatively steady as well, with both yields and spreads trending sideways during the first month of 2017. However, markets got a little choppy in the last few days of the month. Popular backlash to a controversial immigration order sparked a retreat in equity markets on concerns that the big three initiatives (tax reform, deregulation, and infrastructure spending) could be delayed or more difficult to push through given heightened partisan tensions. To that end, much of the post-election optimism in equity markets was related to the big three, particularly corporate tax reform.
From a data perspective, the post-election trend of stronger survey-based measures and lagging/mixed activity measures held throughout the month. On the survey side, business measures have improved with ISM manufacturing rising in January to the highest level since March 2015 (services index highest in more than a year). Small business optimism also has been robust, driven primarily by expectations for better business conditions going forward.
The initial estimate of Q4 GDP growth was 30 basis points (bps) below expectations at 1.90%, but there were some promising components, particularly domestic demand and business investment. An increase in the trade deficit (reduced exports and surge in imports) subtracted 1.7% from the headline growth figure and completely offset the positive contribution from personal consumption. Business investment was a drag on growth for the prior four quarters, but nonresidential investment added 30 bps to overall growth. This is the most since Q3 2015 and it is closer to the 20-year average contribution of 44 bps. The surge in imports growth corresponded with a 2.8% growth rate in final sales to private domestic purchasers (up 40 bps from prior quarter). In the end, however, this suggests that the economy remains in the 2% post-crisis trend, which is well below the average growth rate for prior expansion cycles post-World War II. Based on the survey-based data, there is clearly optimism going forward, but we still need to see a material upward shift in actual activity-based data before expecting GDP to break this trend.
In the updated Summary of Economic Projections (SEP) released after the December 14 FOMC meeting, the median participant forecast for the fed funds rate suggested expectations for three rate hikes in 2017. At the same time, the median GDP forecast was largely unchanged for the foreseeable future in the 1.8% to 2.1% range. Therefore, breaking from the current GDP trend is not necessarily a requirement for the Fed to continue with the policy normalization process. Several Federal Reserve leaders have recently stated their belief that the labor market is at or near full employment, and as such, they continue to voice desire for “gradual” tightening. Fed Chair Janet Yellen added that she sees no signs of an economy overheating. If the economy were to heat up, the FOMC would be expected to become more aggressive toward policy normalization, including balance-sheet reduction via QE reinvestment tapering.
The Fed has been fairly consistent in its guidance that asset holdings (namely Treasuries and agency MBS) would not be reduced until the “normalization of the federal funds rate is well under way.” Many market participants and analysts are interpreting “well under way” to mean a 1-2% fed funds rate; and if the Fed were to actually move forward with three hikes this year, then the funds rate would end the year at 1.5%. Therefore, assuming the economy cooperates (a big “if”), any reduction in reinvestments would likely occur in early 2018, according to this assumption. There is much debate about how much balance sheet shrinkage may occur (i.e., how much reserves does the Fed choose to leave in the banking system), as well as whether the Fed would be more focused on MBS or Treasuries initially. For MBS, the end of QE reinvestments could push option-adjusted spreads 20-30 bps wider depending on the method/timing of the reduction. In 2014, the Fed released guidance on how it may choose to reduce the balance sheet, and with regard to asset holdings, it expressed a desire to ultimately only hold Treasuries in its SOMA, which some are taking as a hint that MBS will be the initial and primary focus. Because of this, any material improvement in the underlying economic trend will likely push MBS spreads wider and the Treasury curve steeper in anticipation of a more hawkish/aggressive Fed.
Another wildcard in all of this speculation (and it is just that – speculation) is what the leadership of the Fed will look like one year from now. Janet Yellen’s current term as chair expires in February 2018, and no one yet knows what President Trump’s preferences are from a monetary policy perspective. There has been much criticism from conservatives in recent years regarding the Fed’s balance-sheet expansion and perceived lack of transparency. If she were replaced by a much more hawkish chair, all bets are off.
The future trajectory of price inflation will have a major influence on the aggressiveness of the Fed (or lack thereof), and the market measures of inflation expectations have risen steadily since last summer. As illustrated in Exhibit 1, break-even yields for 5-year Treasury Inflation Protected Securities (TIPS) are up 75 bps since August and are currently at the highest level since summer 2014. TIPS break-even yields are a popular gauge of market inflation expectations; and, in the post-crisis environment, higher inflation expectations have failed to evolve into sustained actual inflation above the Fed’s minimum target (2%). If the labor market is at full employment, as Fed leaders are suggesting, wage and core inflation pressures should follow.
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