US Fed Interest Rate Policy Update

Three months ago, I had written about the US Fed's interest rate policy. (See articles dated March 22, March 27, and April 23.)

Here's an update.

Janet Yellen spoke last week at her quarterly press conference. She advised listeners not to spend time wondering whether the first rate hike will come in "September or December or March".  Instead she advised her audience to concentrate on the pace of the rise in rates and said that the pace would be "gradual".

Her words hint at the possibility that the first rate hike may not occur this year. Prior expectations were for this to occur in September. Prior to that, expectations were for this to occur in June (this very month).

The Fed Funds futures market -- used for hedging purposes -- is implying with virtual certainty that there won't be a rate rise in September. In contrast, at the beginning of this year the futures market was signaling with virtual certainty that there would be a rate rise by then.

The futures market is now signaling a 50-50 chance of a rate rise by the end of the year.

Expectations about the timing of first rate rise continue to get postponed.


Excerpted from a Financial Times article printed on 20 June/21 June, p. 16.


Afterthought:  Bond expert Jeff Gundlach, who is CEO and chief investment officer of Doubleline, doesn't think that the Fed will raise interest rates this year. He shared his mind on June 3. See article here.

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Concept of Time

"Italians' concept of time is radically different from most people I know in New York, and I'm realizing that I don't have to accomplish 29 things every day, and read the entire New Yorker while drinking my coffee from a paper cup and texting on a treadmill."

Jhumpa Lahiri, 47

Pulitzer-Prize-winning writer

Human Connection

"Here [in Rome at the local food markets], you know the person who bakes your birthday cakes, who makes your salami and cheese every day, and the people who sell everything you put in your body. And they know everything you put into your body because there's this deep, human connection that you create day after day."

Jhumpa Lahiri

Excerpted from Financial Times, 23 May/24 May 2015, page 16 of House & Home FT Weekend.

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Excerpts from Bill Gross' 

Investment Outlook of May 4, 2015

A Sense of An Ending

Here's the link to Bill Gross' investment outlook report of May 4. (Note added on Dec. 5, 2015: They moved the article. Here's another link.)

The following comments stood out for me.

1) "[S]uccessful, neither perma-bearish nor perma-bullish managers have spoken to a “sense of an ending” as well. Stanley Druckenmiller, George Soros, Ray Dalio, Jeremy Grantham, among others warn investors that our 35 year investment supercycle may be exhausted."

2) "Since capital gains have dominated historical returns, investment managers tend to focus on areas where capital gains seem most probable. They fail to consider that mildly levered income as opposed to capital gains will likely be the favored risk / reward alternative."

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20-year Interest Rate Forecasts

On September 24, 2014, I wrote about Joseph Stiglitz' review of Martin Wolf's latest book. 

In that article, the topic of interest rate forecasts came up. 

I had written that the Geneva Report was predicting that interest rates worldwide would have to stay low for a "very, very long" time to enable households, companies, and governments to service their debts."

An article published in the Financial Times on April 18, 2015 puts numbers to these predictions. The prediction is from Micheal Gavin at Barclays. Michael Gavin holds a PhD in economics from MIT, according to his LinkedIn profile.

Quoting from this article, "Mr Gavin estimates that all things being equal the natural real interest rate will rise by about 1 percentage point over the next five years, 2.25 percentage points over the next decade, and 3.5 percentage points over the next two decades."

Critics are likely to dismiss these forecasts as being unreliable. After all, who can say what the world is going to look like in 20 years? Nevertheless, I think that these forecasts ought to figure into one's thinking.

For reference, as of the time of this writing, the 10-year Treasury yield stands at 1.96%. The general expectation is for the Fed to raise interest rates sometime in the second half of 2015. This would be the first rate hike in nearly a decade. The Fed has held the Fed funds rate at close to zero since the Great Recession of 2008/2009.

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Stiglitz: Three Steps to Solve Income Inequality

On September 24, 2014, I wrote about Joseph Stiglitz' review of Martin Wolf's latest book. In that article, the topic of income inequality came up.

This month, Joseph Stiglitz' own book came out. In it, he proposes three steps to solving the income inequality problem in the US.

Yahoo had an article on the book which is entitled The Great Divide: Unequal Societies and What We Can Do About Them.

Stiglitz' three steps to solving the income inequality problem pertain to reforming:

1. tax laws
2. corporate governance laws
3. educational system

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US Fed's downward revisions:

What does it all mean?

After reading my previous post ("US Interest Rate Forecasts: Policy Maker vs. Market Forecasts", March 22, 2015), a friend who is not in the field of finance asked, "What does all this mean to the average reader?"  

Here's what I believe it means, and it's a matter of interpretation.

1) If interest rates are of concern to you, perhaps because you have borrowed money at a variable rate and would be adversely affected by an interest rate increase, you shouldn't get too worked up about the prospects of rising interest rates. They are likely to increase less than you were expecting, and later than you were expecting.

2) Since the Fed's mandate is to contribute to price stability, and since it raises interest rates to combat inflation, we now have reduced inflationary expectations associated with the Fed's downward revisions.

3) To the extent that low interest rates lead to higher asset prices (e.g. stock market prices, bond prices, real estate prices), this trend is likely to continue, all else being equal.

4) The US economy, despite being the best recovering economy in the world today, is still not strong enough to support higher interest rates. The rule at work here is that the more economic growth there is, the higher the prevailing interest rate. (In reality, it's the long-term interest rate that mimics the rate of prevailing economic growth. It is set by market forces. However, the long-term interest rate is correlated with the short-term interest rate over which the Fed has direct control.)

5) The Fed cannot always have things its way because there are other forces at play which are beyond its control. These would be market forces: the US dollar has appreciated because of market forces, because of individual decisions. The appreciated dollar will probably perform the job of Fed tightening and put a dampener on economic activity despite interest rates remaining low.

Side note: These individual decisions were primarily caused by the ECB's announcement last January to start QE (quantitative easing) in Europe from March 2015 through September 2016 and at the monthly rate of 60Bn Euros.  This has the effect of raising government bond prices in Europe and reducing their yields. Today, bond holders stand to earn more interest (or yield) on US government bonds than on their European counterparts. Hence the appreciation of the US dollar.

6) The Fed's policy guidance ought to be interpreted not in a vacuum but in the context of what the futures markets are saying. In this case, not only has the Fed revised its own projections downward, but the futures market is predicting interest rates that are even lower than the Fed's lower projections. Market prices represent the thinking of a large number of economic players who have voted by putting their money where their mouth is. They cannot be taken lightly.

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Getting more speculative,

I have read that that one reason that the Fed wants to raise rates sooner than later is because they are afraid of a bubble forming in the US equity markets. (But the Fed's mandate is not to prevent asset bubbles! It's to maintain price stability and full employment.)

I have also read that the Fed wants to raise rates sooner than later so that the next time that there's a recession, there would be room for lowering them. So the thinking is that if rates are low by the time that the next recession arrives, the Fed would have to use other means besides lowering interest rates in order to jump start the economy. But that would be nothing other than QE (quantitative easing)! Again? In what amount? What would that do to global confidence in the US dollar as the world's reserve currency? (Readers may want to do a Google search on "reserve currency" and read further ... E.g. Wikipedia article on reserve currency.)

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US Interest Rate Forecasts:

Policy Maker vs. Market Forecasts

Last Wednesday, many listened to the Fed's statement as to when it expected to raise interest rates. The Fed funds rate has been at its current level since 2008; source.

Previously, concerns about a strong dollar had led many to speculate that the Fed would postpone a rate increase planned for an April-June time frame. The US dollar has appreciated almost 25% since May of last year versus the Euro. (1 Euro is worth $1.0817 today versus $1.3862 last May. Data source for historical exchange rates.) A strong dollar acts as monetary tightening for US exporters. It reduces earnings from goods and services sold abroad when translated back into dollars. (See afterthought at the end of this post.) 

Fed chairwoman Janet Yellen mentioned weaker forecasts of inflation and a downgrade to people's assessments of the long-run normal unemployment rate. Both of these imply postponement of rate increases.

There were dramatic reductions in median forecasts for official interest rates. 

FOMC members' median interest rate projections for 2015, 2016, and 2017 were reduced by 50-75 basis points from last December's projections (i.e. 3 months ago). 

However, futures markets are forecasting even lower rates than the Fed.

The FOMC's latest projections for the Fed's overnight borrowing rate are:

0.625% by 2015 year end, down from the previous forecast (last December) of 1.125%,

1.875% by 2016 year end,

3.125% by 2017 year end.

However, the futures markets' forecasts are:

0.5% by 2015 year end,

1.25% by 2016 year end,

1.85% by 2017 year end.

The Fed fund's rate is currently 0.12%; source.

(As excerpted from the Financial Times, March 20, 2015, page 24.)

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The above data is in terms of levels. We can also express them in terms of change in level. Then, the Fed's latest projected path of rate increases becomes: 

+0.5% change by 2015 year end,

+1.25% change by 2016 year end, 

+1.25% change by 2017 year end.

Meanwhile, the futures market thinks that the path of rate increases will be more like:

+0.38% change by 2015 year end,

+0.75% change  by 2016 year end,

+0.6% change by 2017 year end.

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Several observations are noteworthy. First, the market thinks that the Fed won't increase rates by as much as the Fed itself is projecting. This is obvious: In the last two data sets above, every line in the second data set is less than in the first data set. 

What is less obvious is that the market thinks that the third leg of tightening (+0.6%) will be weaker than the second leg (+0.75%). On the other hand, the FOMC is projecting identical tightenings (+1.25% and +1.25%). This suggests that the market sees economic weakness 2-3 years out whereas the FOMC doesn't ... Economic weakness would call for lower interest rates.

Furthermore, the market thinks that the "oomph" of the second leg (+0.75%) will be twice that of the first leg (+0.38%). In contrast, the FOMC's oomph for the second leg (+1.25%) is projected to be 2.5 times that of the first leg (+0.5%). This suggests that the market doesn't think the economy needs or can take that much tightening 1-2 years out.

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It will be interesting to keep track to see who ends up being right. 

It is important to remember that ultimately, it is the FOMC itself which sets the Fed funds rate, whereas the futures market can at best forecast it. The FOMC meets eight times a year: meeting calendars of the FOMC.

Previous expectations of a rate hike as early as June have now been replaced with September.

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Background

1. Question: Why is the Fed funds rate important? Answer.
2. Wikipedia article explaining the Fed funds rate.
3. FOMC = Federal Open Market Committee. About the FOMC.
4. Fed = US Federal Reserve System. Wikipedia article on the Fed.

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Why a strong dollar is bad for US corporate earnings

During a portion of last year (2014), when the US dollar appreciated by 5%, overseas earnings of US corporations fell by 7%. So, the multiplier effect exceeds one.

Furthermore, a good portion of S&P 500 company earnings come from overseas. Approximately 40% of S&P companies have overseas revenues, and 261 companies in the index have more than 15% of their revenues outside the US, according to data from S&P Dow Jones Indices. (Source: http://www.ft.com/, Jan. 19, 2015, "S&P 500 earnings face dollar headwind".)

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