Fed Watch: Right on Schedule

kevin-temp2
Head of Fixed Income Strategy
06/14/2017

Here we are halfway through the FOMC meeting cycle for 2017, and the policy makers appear to be right on schedule with their projected rate hikes for the year. The Federal Reserve’s (Fed) own internal projections for the current calendar year projected three rate increases in the Fed Funds target range. With the June rate hike now in the books, the Fed has already implemented two of those increases. Now the key question is: What comes next?

 

Certainly, this week’s rate hike came as no surprise to the money and bond markets. Indeed, the Fed Funds Futures-implied probability placed the odds of such a move at 95% heading into the week. Going forward, there is far less agreement on both the timing for another rate hike and on whether there will even be an additional move in 2017. Another key consideration that has been added to the mix is the Fed’s balance sheet, specifically its holdings of Treasuries, agency debt and agency mortgage-backed securities (MBS). In fact, the Fed provided an updated policy normalization plan on that front for the first time since September 2014 (a topic for an upcoming blog post).

 

Earlier this year, the Fed seemed to be pleased that its dual mandate of employment and inflation appeared to be on the cusp of being attained. While the employment side remains on track, the inflation part has begun to be called into question of late. To be sure, the Fed’s preferred measure of inflation, the price index for personal consumption expenditure (PCE), rose to a five-year high of +2.1% in February, crossing the FOMC’s 2% threshold in the process. However, the latest reading placed inflation at a more modest +1.7%. A similar pattern has emerged on the wage front, as the winter peak reading of +2.8% has drifted back to +2.5% in the spring. As long as there is no further slowing in price pressures, the voting members will probably continue to feel that inflation is on its way back to their 2% objective and not act as a deterrent to any future moves.

 

The timing for the next Fed Funds increase could also be predicated upon the Fed’s decision on when to begin phasing out its reinvestment policy for the aforementioned securities. Up to this point, the policy makers seem to be guiding the markets into thinking that when they make the announcement regarding their balance sheet, the voting members would take a little pause in their rate-hiking cycle in order to assess any potential market ramifications (a lesson learned from the taper tantrum). At the present time, there does seem to be a consensus developing in the fixed income markets that an announcement regarding reinvestment policy could occur at the September FOMC meeting. If the markets digest the balance sheet announcement without any visible dislocations, and economic and financial conditions continue to match the Fed’s own outlook, the policy makers can be expected to follow up with a third rate increase at the December FOMC meeting.

 

Conclusion

 

Based on price action prior to the June FOMC meeting, the U.S. Treasury (UST) market did not seem to discount the potential policy actions that could be forthcoming later this year. Following the May jobs report, the UST 10-Year yield fell to 2.15%, the lowest reading since right after Election Day. In our opinion, if the Fed does ultimately tighten monetary policy by implementing both rate hikes and balance sheet normalization, UST yields may be susceptible to some upside pressure.

 

Unless otherwise noted, data source is Bloomberg as of 6/9/2017.

 

Important Risks Related to this Article

Fixed income investments are subject to interest rate risk; their value will normally decline as interest rates rise. In addition, when interest rates fall, income may decline. Fixed income investments are also subject to credit risk, the risk that the issuer of a bond will fail to pay interest and principal in a timely manner or that negative perceptions of the issuer’s ability to make such payments will cause the price of that bond to decline.

About the Contributor
kevin-temp2
Head of Fixed Income Strategy
As part of WisdomTree’s Investment Strategy group, Kevin serves as Head of Fixed Income Strategy. In this role, he contributes to the asset allocation team, writes fixed income-related content and travels with the sales team, conducting client-facing meetings and providing expertise on WisdomTree’s existing and future bond ETFs. In addition, Kevin works closely with the fixed income team. Prior to joining WisdomTree, Kevin spent 30 years at Morgan Stanley, where he was most recently a Managing Director. He was responsible for tactical and strategic recommendations and created asset allocation models for fixed income securities. He was a contributor to the Morgan Stanley Wealth Management Global Investment Committee, primary author of Morgan Stanley Wealth Management’s monthly and weekly fixed income publications, and collaborated with the firm’s Research and Consulting Group Divisions to build ETF and fund manager asset allocation models. Kevin has an MBA from Pace University’s Lubin Graduate School of Business, and a B.S in Finance from Fairfield University.