US rates: Has the fuse been lit?

To our surprise yesterday’s Fed statement and projections not only re-confirmed the probability of a rate increase later in the year but also continue to forecast three further rate increases in 2018. Furthermore, the Fed announced the pace of reduction in its balance sheet which, while an initially modest US$10bn per month in October will rise to US$50bn per month by the end of 2018. The initial market reaction has been for the yield curve to flatten further as investors price in an increased probability of a Q4 rate rate increase while US 10y bond yields rose by only 3bps. Equity markets may be sanguine for now but we view this monetary headwind as a slow-burn fuse which may challenge investors again during 2018.

The recent Fed decision to stay the course on the trajectory of interest rate increases also takes the pressure off policymakers at the ECB. Here policymakers are reportedly split on what to do next with fears of an ever increasing euro exchange rate weighing on the decision on how to taper eurozone QE. While it is clear in our view that the ECB will only tighten very gradually, the bounce in the dollar may on balance lead to a slightly more hawkish outcome when the ECB meets in October. When added to the Bank of England’s hawkish comments which indicate a rate increase in November is on the cards, the conditions for a synchronised tightening of monetary policy appear to be in place.

Furthermore, in response to questions in respect of asset prices, Janet Yellen did not disagree with the view that the Fed’s policies had led to a rapid increase in asset prices. Her point was that the policies which the Fed followed were necessary to achieve the Fed’s Congress-mandated objectives of price stability and maximum employment. However, this argument also leads back to Yellen’s earlier comments that the Fed is not concerned about asset prices, except for when the implications may be systemic. Furthermore, she believes the banking system is significantly more robust due to increased and higher quality capital post-2008. Taken together, this implies in our view that Fed policy is now a headwind for asset prices and the Fed put strike price (or the decline necessary to change the course of monetary policy) is meaningfully below current market levels.

We do however also note that the balance sheet reduction was clearly stated to be on a pre-set course, absent a material change in the economic outlook. This is in our view a brave policy move as the effect of the increased supply of longer-term assets on long-term rates is an unknown. It is also a clear statement that the Fed views balance sheet policy as a crisis management tool. All other things being equal, this is likely to increase short-term interest rate volatility as the stance of monetary policy becomes solely reliant on short-term rates and if necessary forward guidance.

We also see hints the Fed is setting itself up for potential staff changes with Yellen laying out a quasi-fixed policy on balance sheet reduction and her reiterated commitment to the post-2008 bank regulation regime. The divergence between market-implied expectations for interest rates (which currently see rates at 1.5% by end-2018) and the Fed at 2.1% may be in part due to investors’ assessment of probability of the appointment of dovish policymakers over coming months and stumbling US core inflation during 2017. It seems unlikely in our view that statistical quirks or the negative term premia highlighted by Yellen could account for such a large gap.