Hello and welcome to this podcast – I’m Nick Parker at J.P. Morgan.
Today we’ll be talking about a theme that is always a major focus for global investors – and especially now: The U.S. Federal reserve and the direction of interest rates in the coming months.
The current tightening cycle began in late 2015 and is expected to continue well into 2019. But some key questions remain:
Right now we’re also seeing a flattening of the yield curve for U.S. Treasuries which historically has been a harbinger of recession.
And on top of this, Chairman Jerome Powell is facing criticism from President Donald Trump, who is pressing for a slowdown in interest rate hikes.
So certainly a lot to talk about. And joining me to discuss this is Chief U.S. Economist, Michael Feroli, and head of U.S. Rate Strategy, Jay Barry. Gentlemen, thank you to you both for joining us today.
So one of the first things we wanted to talk about was J.P. Morgan made the call at the start of the year when other people didn’t that it was going to be four rate hikes into 2018. As we approach the end of the year, are we standing by that? Are we expecting one more?
Oh, very much so. Now we're seeing more convincing evidence of wage acceleration, still very solid job creation, still very low unemployment rates. And it was actually about this time last year that we went to four hikes for this year. And it was really motivated not so much by changes in fiscal policy, which certainly buttressed the case for four hikes, but it was really the developments we were seeing in the labor market around this time last year, which gave us confidence that the Fed would be hiking quite a bit this year. And that strengthened labor market is continued. So we do think they will hike in December.
A highly subjective question this, but clearly there's always an ongoing debate when you look at monetary policy about whether the Fed is doing enough to offset concerns over inflation, which are currently higher than its 2% target, or whether they're actually tightening too fast and risking economic growth. What are your perceptions on that?
Personally, I think they're always going to get it wrong, a little bit too fast or too slow. I think sitting here right now, it feels to me like the strategy they have balances those risks pretty well. They're hiking once a quarter, which is not particularly fast by historical standards. And I think what they're aiming to do and what many of them have said they're aiming to do is simply get back to somewhere close to neutral. Hopefully at that point you haven't had an inflation problem bubble up yet.
I mean, realistically, they're pretty much right at target on inflation. Employment, everything looks good. The question is whether everything remains good over the next 12 to 24 months. Hopefully, if they can get to neutral by the middle of next year without an inflation problem, then I think they're well situated to address either overheating or economic weakness. So sitting here right now, it's hard to say whether they're going too fast or too slow, which I guess is the mark of good policy, that the risks feel like they're pretty evenly balanced to us.
And if we look at how the market is, say, pricing inflation, if we're to look at 10-year tips breakevens is a measure of the market's expectations of inflation over the next decade, they've been pretty range-bound for most of the year. They peaked around 220 in the spring. Now we're in the sort of 205 to 210 zone, so not giving you any sense that there is a risk of runaway inflation and not giving you a sense that there's market concern about disinflation coming anytime soon.
You know, in fact, we would argue that tips have not fully adjusted to what has happened that Mike talked about on the wage front, that it seems to us that term breakevens are actually a little bit too narrow relative to what you'd expect, relative to their fundamental drivers. But even if we make that adjustment, they're still not giving any indication of real major concern over inflation.
So trading within a range that you would expect.
And that gets us on to another big talking point, which has been a subject of some interest for the last few months, the flattening yield curve for US treasuries, which is the largest bond market in the world. Essentially, for the uninitiated, the yield measures the difference or spread between short and long-term US government debt. The short-term reflects expectations around Fed policy. And there the yields are rising as prices fall. And long-term yields reflect the outlook for inflation and economic outlook. And there the yields are falling as prices rise. Jay, did I get that right, firstly? And secondly, why is this important?
So first, I think broadly speaking, treasury yields have been rising across the curve this year. It's just that front end yields have been rising at a more rapid rate than long-term yields. And if we think about the yield curve broadly, looking over a much longer history, the main determinant of the shape of the yield curve is expected real policy rate, so policy rates after adjusting for inflation. And therefore, with the Fed now having raised rates by a cumulative amount of 200 basis points over the last three years, it's not surprising that the yield curve is flatter than it was three years ago and that we have been in a flattening trend.
The question that's been asked is, is this the sort of give us an eminent indicator that we're headed towards recession because the yield curve has been a prominent recession indicator in the past? We made the case earlier this year that the bar for the yield curve to flatten in this current tightening environment is much lower than it has been in the past. Or put differently, it's much harder for long-term yields to rise appreciably versus what we've seen in prior tightening cycles. And this is two-fold.
The first is, as Mike mentioned earlier, we are expecting the Fed funds rate to hit 3.5% by year end 2019. While that's high relative to where we've been over the past decade, relative to late in other tightening cycles, it would still leave the funds rate nearly 200 basis points lower than we ended the last cycle in 2004 to 2006. So that's acting as somewhat of an anchor. And then beyond that, the additional compensation that's needed to own a longer term security, what we call the term premium, that has collapsed as well, making it much easier for the yield curve to flatten.
So we'd argue that the signal that you get from the yield curve, while it does tell us that the Fed's tightening and it does tell us that we are somewhat more mature in the business cycle, we're not concerned that it's imminently giving us a signal of recession because of these changing dynamics of the expectation that the Fed funds rate will rise to a lower terminal point than it has in the past, that the extra compensation an investor needs to buy a long-term security has declined, and that even when we adjust for all this, the yield curve is still as flat as it was in call it the third quarter of 2005, which was still a good two years before we actually entered recession. So I think there's a signal. It's just not giving us any sort of cause for concern at the moment.
One other huge issue with the Fed and with monetary policy as we're going forward is essentially the unwinding of QE. Quantitative easing was an unprecedented intervention in the market by the Fed. And as it unwinds its balance sheet with quantitative tightening, what risks do you see going forward, do you think?
Well, why don't you take that, Jay? I mean, coming from the economic, speaking as the economist here, I think the risk is simply that the unwind of QE means that there will be more duration assets supplied to the market, which should push up longer term interest rates, which could be a restraint on economic growth, which is why I turn it over to you, Jay. I don't think we see the quantum of tightening there as large enough to really pose a significant headwind to the economy. I mean, we could get it wrong. I guess that's the risk.
Yeah, I think we look at this. And balance sheet normalization has been running for a little bit more than a year right now. And we can argue that it's been operating in the background and relatively smoothly as the Fed has gradually allowed more and more securities to mature or roll off of its balance sheet.
We do think it is impactful on the term structure. And empirically, looking back over the past decade, we have found that every trillion dollars of QE amongst the developed market central banks has depressed 10-year yields in the US by somewhere between 15 and 20 basis points. So one would think that, as the balance sheet has declined in size by less than half that over the past year, that would have impacted long-term yields by somewhere in the vicinity, call it 7 to 10 basis points, so definitely impactful in moving rates higher, but rather minor compared to what the Fed has done by raising the Fed funds rate over the course of this year as well.
Because we'd argue that the transmission mechanism of the Fed raising its overnight rate by 25 basis points sees about call it between a quarter and a third pass through the long-term rate. So the fact that the Fed has raised rates by 75 basis points this year has probably pushed long-term yields higher by 25 to 30, by probably 25 basis points in itself. So QE mechanically helping to raise interest rates, but really I think that the Fed funds rate is doing the yieldman's work here.
And then all this is taking place as the US is printing more treasuries to fund its deficits. What do you think the supply aspect is going to have on this?
Yeah, so in calendar 2018, we think we're going to see about $1.3 trillion in net treasury issuance. It will be the largest we've seen in six or seven years owing to the Fed balance sheet runoff but also to increasing deficits following the passage of the tax cuts and the bipartisan Budget Act earlier this year. So again, more treasury supply contributes to higher yields.
But the one thing to say here is that the way the treasury finance is is quite important as well. So the Treasury Department has spent the better part of the past decade attempting to lengthen the average maturity of its debt profile to reduce rollover risk and reduce risk overall. It's made a 90 degree turn over the course of the past 12 months and said, OK, this lengthening in maturity that we've done over the past decade has been useful in reducing risk and reducing cost. But we're where we need to be. So by function of that, it means that most of the changes and increases in issuance that we're seeing this year are coming largely at the front end of the curve. So altogether, the fact that more of this is coming at the short end of the yield curve rather than the long end is somewhat dampening the impact on interest rates.
One thing I did want to get your perspective on, your shared perspective, was the criticism that Jerome Powell's been facing recently from President Trump over the current tightening cycle. President Trump has described it as his quote, "greatest threat." Now, obviously the Fed is independent. But some have called for a more pragmatic approach towards this issue of independence. For instance, Larry Summers, wrote, in the FT just recently, quote, "It is foolish to suppose a nation's financial policies should be conducted independently of its elected officials." Do you think that these kind of political criticisms by the president would have any effect on monetary policy?
I think everyone probably has their own guess. My guess is that Powell is the type of guy who is going to operate from a good government perspective and try and do what he thinks will best achieve the congressionally mandated dual mandate that they've been given. And so you're right that the Fed, or I guess Summers', I think, point is correct. But I forget who said that the Fed is independent within government but not independent of government. So it has its objectives set to it by Congress, and then it has the independence to try and achieve those objectives.
So it's not simply just off doing its own thing, right? So they're trying to do what they have been tasked with by Congress. And I think, ultimately, Powell as well as the others on the board and on the committee, I believe, will try to do the right thing to achieve that mandate. I don't think they'll be influenced by the president. But everyone of course probably has their own opinion on that, but that's my opinion.
The dual mandate being inflation and employment.
2% inflation, low sustainable unemployment.
Right. And, Jay, your perspective, do you think, on the role of political pressure?
I mean, not too different than Mike's. And I guess if we were to take a step back and, from 50,000 feet, ask ourselves, what do you think interest rates would be doing if we knew that the unemployment rate was sitting at its lowest level in nearly 50 years and inflation was at the Fed's and 2% interpret a target, and I think we'd be fervently saying that the committee would be raising rates. So I wouldn't call it the biggest threat to the economy. But I don't think we should be shocked if the Fed's on the normalization path here. And to the extent that it's an independent institution and Powell has been a member of the committee before the president appointed him as Chair, it would seem that he would follow along the same path that the committe has been on for the last couple of years.
So just looking ahead to next year, you mentioned that you're seeing 3.5% by the end of 2019. Let's just talk about how this tightening cycle might play out in a few different asset classes, if we could. And, Jay, perhaps we could begin with you in fixed income. And in particular, do you think US yields are still looking attractive when you consider other fixed income assets around the world?
So broadly speaking, we actually think that, though nominal yield spreads have widened, largely because the Fed is raising rates-- so optically, treasuries look much more attractive than, say, bunds in Germany or gilts in the UK or JGBs in Japan. After we adjust for call it the cost of hedging currency given the fact that the Fed is indeed raising rates while the rest of these central banks are keeping rates on hold, we'd argue that the relative value of treasuries has actually come down relative to where it's been over the last few years.
So really, what that means is that, for investors who are funded in their local currencies in Europe or in Asia, it's become much more expensive to buy treasuries than it did, say, three or four years ago. And this largely stems from the Fed tightening policy. So what we see going forward is nominal yields in the US rising further. And we have 10-year US yields hitting 340 by the middle of 2019 and 350 by the end of the third quarter.
But if we're right and the market continues to price and more tightening from the Fed, while we don't expect the ECB to lift off until the third quarter of next year and the BOJ to continue to ease, that would indicate that treasuries are going to continue to appear more expensive from a global investor's mind. So attractive from the U.S. investor's perspective but less attractive globally.
And, Michael, I wanted to ask you briefly about the consumer sector, if we could. But before we get to that, I just wanted to ask you how you saw a timetable in 2019. If we're moving from a range of 2.0 to 2.25, now to 3.5 at the end of 2019, how do you think that will play out?
So really, since late last year, they've been on a once-a-quarter hike timeline. And we see that more or less playing out similarly next year, so one hike a quarter. Next year they will have press conferences at every meeting, so that does open up a little bit more possibility that the timing could get a little more interesting. But right now we think, given the macro backdrop, once a quarter appears about right. I mean, obviously, it's kind of hard to say for sure for an event that's, in some cases, more than 12 months away. But that's our baseline outlook.
And as you see rates rising in this way, what does that mean for the consumer sector, do you think, in the broader US economy—
--that relies so heavily on consumers?
Yeah, I think we're already, to some degree, starting to see some of that. So beginning of this year, mortgage rates backed up, and that has slowed the housing sector down. It seems like that may have also been one of the reasons auto sales have been a little bit so-so this year, right? So those are the two most heavily leveraged consumer purchases.
Outside of those categories, you haven't seen a real big slowing in consumer spending. If anything, consumer spending has been doing quite well. So we do think-- if you look at household balance sheets, they are quite a bit less leveraged than they were in the last cycle. And so we think consumers probably aren't going to be too adversely impacted by Fed tightening.
You know, eventually, Fed tightening will bite. That's kind of the whole point. And it could come through any number of channels. It could come through a stronger dollar, weaker asset prices, weaker stock prices. But right now the consumer doesn't appear that vulnerable to a rate hike cycle.
Fascinating stuff, gentlemen. Thank you very much. Chief U.S. Economist, Michael Feroli, and head of U.S. Rate Strategy, Jay Barry.
(V.O.) This communication is provided for information purposes only. Please read J.P. Morgan research reports related to its contents for more information, including important disclosures. ©2018 JPMorgan Chase & Co. All rights reserved.
Since late 2017, the Federal Reserve has raised rates once a quarter and that trend is expected to continue, according to J.P. Morgan Chief U.S. Economist Michael Feroli. The projected tightening cycle comes despite pressure from the White House to slow down interest rate hikes. Underpinning the current cycle is stable inflation and low unemployment which comprise the Fed’s dual mandate.
Given this outlook for interest rates, Head of U.S. Rate Strategy Jay Barry predicts the yield on the benchmark 10- year U.S. Treasury will hit 3.5% by the end of the third quarter.
This is expected to further flatten the yield curve, a dynamic which has historically been an indicator of looming recession. However, Barry explains that in this cycle, it is harder for long term yields to rise as interest rates are expected to peak at a lower level than in the past.
From the consumer standpoint, rising interest rates have already increased the cost of mortgages and car loans, prompting a softening of demand in the housing and auto sectors. But overall Feroli expects consumer spending to remain resilient in the coming months.
A decade after the collapse of Lehman Brothers, J.P. Morgan takes a look back at the response to the financial crisis that reshaped financial markets and the global economy.Read more about 10 Years After the Financial Crisis
Excerpts from our award-winning Global ResearchExplore about Global Research
Explore some of the key considerations for central banks in adopting cryptocurrencyRead more about Can a Central Bank Use Cryptocurrency?
This communication is provided for information purposes only. Please read J.P. Morgan research reports related to its contents for more information, including important disclosures. JPMorgan Chase & Co. or its affiliates and/or subsidiaries (collectively, J.P. Morgan) normally make a market and trade as principal in securities, other financial products and other asset classes that may be discussed in this communication.
This communication has been prepared based upon information, including market prices, data and other information, from sources believed to be reliable, but J.P. Morgan does not warrant its completeness or accuracy except with respect to any disclosures relative to J.P. Morgan and/or its affiliates and an analyst's involvement with any company (or security, other financial product or other asset class) that may be the subject of this communication. Any opinions and estimates constitute our judgment as of the date of this material and are subject to change without notice. Past performance is not indicative of future results. This communication is not intended as an offer or solicitation for the purchase or sale of any financial instrument. J.P. Morgan Research does not provide individually tailored investment advice. Any opinions and recommendations herein do not take into account individual client circumstances, objectives, or needs and are not intended as recommendations of particular securities, financial instruments or strategies to particular clients. You must make your own independent decisions regarding any securities, financial instruments or strategies mentioned or related to the information herein. Periodic updates may be provided on companies, issuers or industries based on specific developments or announcements, market conditions or any other publicly available information. However, J.P. Morgan may be restricted from updating information contained in this communication for regulatory or other reasons. Clients should contact analysts and execute transactions through a J.P. Morgan subsidiary or affiliate in their home jurisdiction unless governing law permits otherwise.
This communication may not be redistributed or retransmitted, in whole or in part, or in any form or manner, without the express written consent of J.P. Morgan. Any unauthorized use or disclosure is prohibited. Receipt and review of this information constitutes your agreement not to redistribute or retransmit the contents and information contained in this communication without first obtaining express permission from an authorized officer of J.P. Morgan.