USD strength will end as Fed expectations are peaking.
(this is an excerpt from last week's flagship report)
It have been a painful couple of months for the ideas in our thematic model portfolio. I have remained convinced that both interest rates and inflation expectations have been peaking just as they have in Q2 of the past several years. I just haven’t seen the inflation pressures that many others have espoused and frankly, talking about topping interest rates when yields across the curve were making multi-year highs has been a pretty lonely existence. However, I think we are getting more and more evidence that hawkish expectations for the Federal Reserve may be cresting. It isn’t due to noisy events like President Trump talking about auto tariffs or the cancellation of the North Korean summit. It isn’t about concerns over Turkey or fears that US / China trade peace may only be fleeting.
It is about the fact that the global inflation outlook is not threatening, and the Federal Reserve is outlining a slightly more dovish tone.
As can be seen from the following chart of US 10-year inflation breakevens, inflationary expectations appear to be topping.
The Fed minutes from the May meeting were somewhat more dovish than expected, with a growing confidence in the inflation outlook and a sense that the governors would allow the economy to run hot i.e. allow inflation to move above the 2% target for a period. While this language is rather ambiguous, there is a school of thought that the says maybe expectations of four hikes in 2018 and another four hikes in 2019 is far too hawkish. Now, I am not going to join the throng of sell side analysts who psychoanalyze every word in the minutes for hints of a dovish or hawkish tilt. What I am going to do is run you through the very sound thinking of San Francisco Fed President, John Williams and why I think that the Fed will stall after another four more hikes or within a range of 2.50% - 2.75%.
John Williams and his passion for r-star
On May 15th, Mr. Williams presented at the Economic Club of Minnesota. The topic, one of his favorites, was the idea of the natural rate of interest or r* (star). Here is his explanation of r-star:
“R-star is what economists call the natural rate of interest; it’s the real interest rate expected to prevail when the economy is at full strength. While a central bank like the Fed sets short-term interest rates, r-star is a result of longer-term economic factors beyond the influence of central banks and monetary policy.”
This is a longer run assessment of the long run equilibrium rate and takes in to account factors such as productivity, demographics and the demand for safe assets. While this is not a predictor of the speed of tightening as the cycle will determine that, it does give us a good indication about where the longer term neutral rate of interest is, given these structural factors. And where is this longer term neutral rate? Mr. Williams explains:
My own view is that r-star today is around 0.5%. Assuming inflation is running at our goal of 2%, that means the typical, or normal short-term interest rate is 2.5%. For comparison, the median longer-run value of the federal funds rate in the Federal Open Market Committee’s (FOMC’s) most recent economic projections is 2.875%. When put into a historical context, r-star stands at an incredibly low level—in fact, a full 2 percentage points below what a normal interest rate looked like just 20 years ago. This trend is not unique to the United States: Averaging across Canada, the euro area, Japan, and the United Kingdom, a measure of global r-star is a bit below 0.5%.
As the dot plots indicate, the FOMC sees the Fed funds rate above the natural rate by some 50bps in 2020. This could be due to a number of factors but primarily a notion that the expectation for inflation in the medium term (next 2 years), is going to significantly over shoot 2% and force the Fed to make policy restrictive.
We need to distinguish between the long term natural rate and the impacts of the cycle. In the near term, the Fed has to focus on the data, on this specific cycle and respond accordingly. There are reasons to believe this cycle could be different, some of which could challenge Mr. William’s assumption. The fiscal stimulus at full employment could temporarily see inflation and growth spike. Arguments that tax cuts could lead to higher productivity are discounted by Mr. Williams and productivity specialists like American Enterprise Institutes (and Expert Series guest), Martin Baily. That said, I continue to believe the incredible innovation we have witnessed in recent years will eventually translate into official productivity improvement.
For example, if digital productivity gains that we have witnessed in the past three years evolve into gains elsewhere in the US economy, the r-star and the trend rate of growth must rise. This is an older chart from Expert Series contributor, Bret Swanson, but illustrates the point.
Can we be confident that r-star is as low as Mr. Williams believes? Without going into a long-winded assessment, his arguments about poor western demographics and the increased demand for safe haven assets are compelling and in line with my own views that long dated yields are capped. With less than $1.8tn of investment grade securities yielding over 4% (IMF), this is incredibly supportive, anecdotally, of his arguments. Mr. Williams elaborates:
“Three key global developments have caused r-star to come down in a number of developed economies over the past two decades: changes in demographics, a slowdown in productivity growth, and heightened demand for safe assets”.
“These three issues—demographics, productivity growth, and the demand for safe assets—all point to an r-star that’s set to hold its position low in the sky for quite some time.”
The key summary from the speech is as follows:
“But even as we raise rates, I’m conscious that the fundamental drivers that govern r-star are lower than we’ve seen in the past. With a new normal for short-term rates of around 2½%, interest rates are likely to remain low relative to historical experience.”
If neutral is below 3%, will the Fed get to neutral and stop? The Fed could pause in March2019
If the thinking of Mr. Williams is correct and inflation is capped at 2%, will the Fed stop tightening before policy goes restrictive i.e. at 2.75%? It is all about the inflation outlook. Regular readers know my views: Global inflation is capped, and this should be enough, over the course of the next nine to twelve months to prompt the Fed to cease tightening at or slightly below the neutral rate of 2.875%. If the Fed stops tightening with cash rates in a range of 2.5%—2.75%, long-term interest rates have made their cycle highs.
I have assumed, as many of you have, that at the end of the tightening cycle, history tells us that the yield curve will invert. Let us not even go that far; let’s assume that fed fund rates and the ten-year yield are flat at 2.75%. That is 20bps points below current levels and while I concede that the path dependency of interest rates could see the yield curve steepen in the near term, it is conceivable that this tightening cycle could be over and done with by March 2019. The tendency is for curves to continue to flatten in the final 12 months of a tightening cycle and while this cycle has been vastly different from others, the odds favor long duration bonds to rally if Mr. William’s assessment is correct.
Picking a turning point in productivity is next to impossible, so the base case for us all should be that Mr. Williams will be right and productivity will remain constant. If this is the case, the outlook for the Federal Reserve should be that they will only tighten on four more occasions and therefore long-dated US yields are capped.
This all points to markets having reached their maximum point of hawkishness for the cycle. Naturally, this will change if inflation reaccelerates, not just in the US, but around the globe. That said, if inflation is capped, as I believe it is, the market will start to look towards the Fed stopping as cash rates approach the long term neutral rate of 2.875%. If Mr. Williams has his way, it would be closer to 2.50%, but let us assume for the sake of this exercise that the consensus amongst the Fed governors is correct. US interest rate markets look fully priced and I would expect yields, especially longer duration sovereign debt, to grind lower for the balance of the year.
The thematic model portfolio continues to own long duration US fixed income. Any over shoot above 3% in the US 10 year will create an excellent opportunity to own yielding assets, especially if expectations for Federal Reserve action over the next several years will be revised lower.
So, what does this all mean for EM?
So, if US rates are capped because the Fed could potentially only tighten another 100bps in this cycle before pausing, the outlook for the USD is down, and the prospects for emerging markets are rosy.
Allow me to be succinct: If expectations for Federal Reserve action are maxing out, then the USD will not move appreciably higher. Yes, spreads matter and if European growth continues to struggle, then the Euro could be in trouble. That said, with European cash rates well below neutral, I believe that this soft patch in growth won’t last long and a slight rebound is coming. The strength in the USD we have witness in the last couple of months will prove to be corrective in a longer-term recalibration lower for the dollar. This will ease global financial conditions and be supportive of risk assets.
I am not going to rehash my constructive scenario for EM on a twotothree-year view. What I will say is that the key factor for EM underperformance over the last few months, fears of a hawkish Fed that led to a USD rebound, are coming to an end.
Psychologically, we have one hurdle to clear and that is contagion fears regarding Turkey.