The FOMC delivered on the expected 25-basis-point increase in its target range for the federal funds rate and has penciled in three more rate hikes for 2018. Of course, all of this future activity is “data-dependent.” How likely is it that the data will justify those three rate hikes, and what could go wrong?
First, the good news keeps coming. Keep in mind that in December the FOMC had only lagging hard information on GDP growth in Q1–Q3 of 2017. They did have fragmentary anecdotal information on Q4 and monthly data on spending and employment. Virtually all that information was positive. There were over 225K jobs created in both October and November. New claims for unemployment insurance during this quarter are about 20K lower than in the third quarter. The unemployment rate was 4.1% for the past two months and FOMC forecasts have it moving even lower. In October consumer spending posted its biggest gain since 2009, driven in part by replacement of autos and cleanup spending in the wake of the hurricanes. Inventory investment is up, and this trend signals additional expectations of future sales, given the strength of real GDP growth, rather than an unanticipated accumulation of unsold goods. Finally, the Atlanta Federal Reserve Bank’s GDPNow forecast suggests that Q4 growth will be 3.3%, the third quarter in a row with GDP growth in excess of 3%. All of this suggests that we go into the New Year with an improving real economy.
As for what the Fed has been doing to reduce the size of its portfolio, from September 28 to December 13, the system’s total holdings of Treasuries, agencies, and MBS have declined by only $1.5 billion, less than might have been expected given the plan put forward by the FOMC. Interestingly, the Fed’s holdings of MBS have actually increased by $12.1 billion, according the Board of Governors’ H.4.1 reports. These small asset adjustments have not had much effect on the term structure. The short end of the Treasury curve moved up before the FOMC December meeting, largely in anticipation of the rate hike; but following the meeting there was a flattening of the long end of the Treasury curve by some 11 bps on the 20-year and by about 18 bps on the 30-year. This flattening continues a trend for 2017, where the spread between the two-year and ten-year Treasury has declined from about 128 bps to about 56 bps.
The flattening of the curve concerns many managers, who worry about investors being tempted to reach for yield without appropriate compensation for credit risk or maturity risk. Thus one of the most frequent questions now is, when will the next recession start? Some believe that the stock market is overvalued, while others argue that although the market is rich, it hasn’t yet reached a level that should generate concern. Moreover, the yield curve is far from inverted, which suggests that a downturn is still a ways out.
What could go wrong? There are clearly plenty of possibilities. First, we are in uncharted waters when it comes to international central bank policy. A flood of liquidity has been created by that policy, and some assert that this liquidity has contributed to dampening volatility in virtually all key financial markets to historic lows. What the policy exit looks like is uncertain, and right now the Fed is rowing against the tide.
Uncertainty in the classical Frank Knight sense is the major concern. There is economic and central bank policy uncertainty and we simply have no way of assessing the probabilities of major shocks that loom on the horizon from a variety of sources. Positive economic growth in Europe and selected parts of Asia continues, but turmoil plagues Latin America including Argentina, Brazil and Venezuela. As for Africa, political unrest and civil wars are destroying more wealth than is being created. Unrest and war continue in the Arab Middle East, and the outcome of the Palestinian and Israeli situation is still far from clear. Then there is North Korea.
All of these uncertainties suggest that investment opportunities with lower risk remain centered on the US and Europe. However, there is an interesting dynamic at play even here when it comes to interest rates. With negative rates still in effect in Europe and the Fed’s continuing on its current path of gradually raising rates, it makes perfect sense for European banks to continue to hold reserves at the Fed at a continuingly widening spread to take advantage of the risk-free arbitrage that currently exists. This practice will put upward pressure on US exchange rates and also bid up Treasury prices on the margin to the extent that foreign banks buy Treasuries. When the ECB and Bank of Japan reverse course, much of this activity will unwind and act to tighten policy here in the US with no action taken by the Fed.
So, while there is room for optimism with respect to the US, cautious is the watchword going into 2018.