Interest Rates – 2018
In 2018, we expect:
• Job growth will continue, albeit at a slower pace than before. That growth will exceed new job market entrants, which will continue to put upward pressure on wage growth.
• We expect GDP to continue its slow move to a higher sustainable rate into 2018 which will pressure the Fed to consider removing accommodation faster than they would like.
• Coupled with inflation readings that will exceed 2%, we see the long end of the yield curve starting to move materially upward along with the short end as the Fed hikes rates 3-4 more times in 2018.
To support our outlook, consider the following.
In 2017 we saw the Federal Reserve meet its rate changing expectations. Median forecasts for the Federal Funds rate suggested 3-4 rate rises. The Fed has now raised rates three times in 2017. As is usually the case, the 2 year US Treasury Note has been moving upward along with the overnight rate. However, what happens further out on the yield curve could have greater long-term consequences for fixed income investors. Long-term rates are not moving upward in this environment, but are actually moving down, raising concerns over the risk of an inverted yield curve and the downsides that can often follow such occurrences.
What is behind this state of affairs?
The simplest explanation is to recall that short rates are most sensitive to Fed policy expectations. Short rates can fluctuate wildly based on how markets think the Fed will interpret new data. In addition, the Fed has been determined to remove its extreme monetary easing by raising rates slowly and methodically. Longer-term yields, in contrast, will take their cues from the outlook for inflation and economic growth. Our interpretation of the flattening yield curve is that markets have accepted the fact of the Fed moving forward with their tightening, but they don’t agree with the Fed that weak inflation is truly transitory and that economic growth is trending upward.
Will this continue, and what will happen in 2018? Consider the inputs to Fed thinking and see where the data takes us.
At 4.1%, the unemployment mandate has been met and exceeded. This is down from the 10.0% peak seen in 2009, and just off the 3.8% low last seen in 2000. We could touch that level again before this cycle ends. And the underemployment rate, which includes those who are employed part time, but are looking for full time work, has dropped from a high of 17.1% down to 8.0%. The low for this measure is 6.8%, also set in 2000. No matter how you measure, lack of employment is not a problem for the Fed.
The St Louis Federal Reserve estimates a number called NAIRU, or ‘non-accelerating inflation rate of unemployment’. This is the unemployment level below which tightening labor markets would trigger inflationary wage pressures, which would impact overall inflation data. This number cannot be observed so it is estimated each month and changes hardly at all from period to period. The latest estimate is 4.7%, which we crossed in March, while growing jobs by more than 2mm annually.
That pace of job growth is down from its peak and we expect it to slow further. Yet it will continue to exceed the 1mm labor force entrants each year and those extra 1mm net open positions are becoming harder and harder to fill. In addition, job openings continue to increase and anecdotal evidence around the difficulty of finding qualified employees grows. This collective pressure will likely increase in the next 12-18 months and will continue adding upward inflationary pressures.
GDP has grown in fits and starts since the last recession, but now seems to be moving to a higher level. The last two quarters have exceeded 3.0% and the latest GDPNow estimate from the Federal Reserve Bank of Atlanta for the fourth quarter is 2.9%. We are in the middle of an inflection point between now and the end of March, 2018 where the possibility of sustained higher growth rates will become clear.
Following the elections in 2016 the soft data (forward-looking surveys) led the hard data (actual economic productivity and growth) by a fair amount. Following Q1’17, the hard data began to strengthen and narrow the gap. This lent more support to the optimistic outlook embodied by small business owners, manufacturers, CEO’s and other business leaders. The profits of public and private companies are growing and expanding at rates not seen in several years. At the moment, it seems the biggest impediment to a continuation would be the ability to find qualified employees to staff additional capacity. We see this challenge as very surmountable with some additional training and wage adjustments.
Meanwhile housing is showing signs of tightness across many markets. Following the recession, homebuilders began to approach business less aggressively, reducing land inventory and limiting speculative construction. They also focused less on entry level housing at a time when more and more young buyers preferred to rent. That is changing. Those younger buyers are now starting families and are looking to expand their footprint and buy a home, leading to increased housing activity and the accompanying transactions that accrue.
In aggregate, this leads to what we see as the biggest risk for the Fed itself. What alternatives exist for the Fed if we are truly on a higher growth trajectory than before? Not many, and none of them will be appealing. All will encompass some accelerated level of easing. This could take the form of faster rate rises or a speedier reduction in the Fed’s balance sheet, or possibly both. The market won’t embrace either of these options well and interest rates will move up accordingly.
Inflation has been the missing link for the dual-mandate Fed and is the primary reason for long-rate stagnation. As the economy slowly takes root and seeks consistent growth from quarter to quarter, the Fed expected to see inflation moving slowly toward their 2% target. They are puzzled as to why, but it doesn’t seem so confusing to us. Really, they were given a gift.
In 2014-15, when the Fed ended their quantitative easing program, their primary worry was being forced to raise rates sooner than they wished. With unemployment moving quickly downward, higher inflation would have forced their hand. Then oil prices dropped from over $100/barrel on the way to $27/barrel in February 2016. And the dollar appreciated, pushing down import prices and adding to a collective downward push to reported inflation.
While lower oil prices hit the energy sector hard, it was an overall benefit to the rest of the economy in the form of lower input prices and the stock market mostly shrugged it off. And the stronger dollar cut costs across the board for imported items, again benefitting input prices. Both conspired to suppress reported inflation and allowed for a great deal of additional flexibility in determining just when to implement their first rate rise in nearly a decade. They took that first step in December, 2015 and have taken four more steps since.
Today we see a different landscape. Oil is far more likely to go up than down; OPEC continues working towards production decreases, world demand continues to grow, and shale production growth is finally slowing. We think oil prices will work their way toward the mid-60’s in 2018, and have an upward effect on inflation.
Dollar strength is retreating as other economies and financial markets are finding their own traction and other central banks start winding up their own easing programs. We see this weakness continuing, putting upward pressure on import prices.
As unemployment declines below NAIRU, the Phillips curve suggests wage inflation should work its way into the inflation number. Despite the attention it receives, inflation is a very lagging indicator. The wage increases we have seen so far have been relatively mild. But when you remember that job openings are growing while hiring is slowing, it is difficult to see how this mismatch can avoid wage growth picking up to the point of having a meaningful impact on overall inflation figures.
Supply and Demand:
The behavior of interest rates is not always just about the Fed and its decisions. Supply and demand play a role too and will impact rates in at least five ways; only the degree of impact is up for debate. Certain investors such as insurance companies and pension funds will always be in the market for duration and long-dated government and corporate bonds are a best way to get it. There is a growing demand from passive investment strategies matched to long-duration benchmarks. The U.S. Treasury is focusing new issuance on shorter-dated maturities such as the two- and five-year notes. US long rates still exceed rates found elsewhere, making it advantageous for certain investors to sell at home and buy rates in the US. And while the Fed is slowly reducing its balance sheet, it isn’t selling, only not reinvesting a small-but-growing portion of its maturities.
In combination, these factors reduce overall supply on the long end of the curve and will play a small role in keeping those longer rates suppressed while the short end rises, but they don’t account for the whole market. There are still a large number of dollar denominated fixed income holders that will sell once the inflation and economic growth landscape clarifies.
We expect to see job growth continue, albeit at a slower pace than before. That growth will exceed new job market entrants, which will continue to put upward pressure on wage growth. We expect GDP to continue its slow move to a higher sustainable rate into 2018 which will pressure the Fed to consider removing accommodation faster than they would like. Coupled with inflation prints that will exceed 2%, we expect to see the long end of the yield curve start to move materially upward along with the short end as the Fed hikes rates 3-4 more times in 2018.