Recent US economic data and Fed comments suggest markets are vastly underestimating the Fed’s capacity to tighten. While much depends on the US economic performance in 2019, we think US rates are likely to rise more than what markets are expecting. This is dollar-positive and EM-negative, to state the obvious.
Late yesterday, Fed Chair Powell poured gasoline on an existing fire in the bond markets, pushing already elevated yields even higher. What did he say? Powell noted that “Interest rates are still accommodative, but we’re gradually moving to a place where they’ll be neutral. We may go past neutral. But we’re a long way from neutral at this point, probably.”
After being unable to break much above 3.10% this past month, the 10-year yield shot up to 3.19% yesterday. Today has seen a continuation of this move, with yields trading as high as 3.23% before stalling out. This was the highest rate since May 2011. The next round number target should be 3.50%, but charts suggest that a test of the February 2011 high near 3.77% is in order.
Implied rates in the longer-date Fed Funds futures contracts have risen, with the market fully pricing in a hike in December. This is followed by two more hikes in 2019, and we are just starting to see a third hike next year get priced in. While this is clearly dollar-positive, we think markets are still underestimating the Fed’s intent to tighten (see below).
Recall that while markets are intently focused on the 10-year yield, the Fed only sets short-term money market rates. With price pressures moving higher, we are not as concerned about the prospects of an inverted yield curve as others might be. Instead, we look for a mostly parallel shift upwards in the yield curve as the Fed continues to hike, with risks tilted towards a bearish steepening if price pressures intensify.
A BRIEF HISTORY LESSON
In light of Powell’s comments, we thought it would be a good time to review what exactly the neutral Fed Funds rate really represents. As the San Francisco Fed writes, it is “the federal funds rate that neither stimulates (speeds up, like pushing down the gas pedal on a car) nor restrains (slows down, like hitting the brakes) economic growth.” It adds that the neutral rate is “often defined as the rate or range of rates consistent with full employment, trend growth, and stable prices. An economy in this state presumably wouldn’t need to be stimulated or slowed by monetary policy.” The neutral rate is often called the “natural” or “equilibrium” interest rate.
While the neutral rate is easy to define, it is very difficult to calculate. Indeed, most economists accept the fact that the natural rate is not static. As former Fed Chair Yellen put it, “The neutral real rate itself depends on a variety of factors – the stance of fiscal policy, the trend of the global economy which shows up in our net exports, the level of housing prices, the equity markets, the slope of the yield curve, or the term premium built into the yield curve. So it changes over time.”
Governor Lael Brainard recently made a distinction between the “shorter-run” neutral rate and the “longer-run” neutral rate. In a speech dated September12, she too noted that the shorter-run rate “does not stay fixed, but rather fluctuates along with important changes in economic conditions. For instance, legislation that increases the budget deficit through tax cuts and spending increases can be expected to generate tailwinds to domestic demand and thus to push up the shorter-run neutral interest rate.” Brainard adds that “Estimates suggest the shorter-run neutral rate tends to be cyclical, falling in recessions and rising during expansions, and our current expansion appears to be no exception.”
With regards to the “longer-run” neutral rate, Brainard notes that past empirical work has yielded many estimates. She notes that “The central tendency of those estimates suggests that the longer-run trend rate is in the range of 2.5-3.5% in nominal terms. This range lines up well with the most recent median estimate of the longer-run federal funds rate in the FOMC SEP, which is just below 3 percent. By these estimates, the longer-run neutral rate has fallen considerably from the estimated range in earlier decades of 4-5%.”
Brainard goes on to note that the only estimates for a “neutral” rate published by the Fed is the “longer-term” rate that’s contained in the dot plots. The latest Dot Plot puts the “longer-term” Fed Funds rate at 3.0%. This too has evolved over time. When the first Dot Plot was introduced in January 2012, the median longer-term rate was 4.25%. The median then fell to 4% in September 2012, 3.75% in June 2014, 3.5% in September 2015, 3.25% in March 2016, 3.0% in June 2016, and 2.875% in September 2016. After edging back up to 3% in December 2016, the median then fell to 2.75% in September 2017. It rose to 2.875% in March 2018 and then 3% in September 2018.
While Powell did not specify which neutral rate he was referring to last night, we assume that it was the shorter-run rate. As Brainard says, “the shorter-run neutral rate, rather than the longer-run federal funds rate, is the relevant benchmark for assessing the near-term path of monetary policy in the presence of headwinds or tailwinds.” In that regard, she goes on to make a very important observation. That is, “The shift from headwinds to tailwinds may be expected to push the shorter-run neutral rate above its longer-run trend in the next year or two, just as it fell below the longer-run equilibrium rate following the financial crisis. Notably, the sizable fiscal stimulus in the pipeline is likely to continue to bolster the short-run neutral rate over the next two years.”
We believe that Brainard’s speech last month largely reflects the consensus outlook at the Fed. That is, Powell’s comments yesterday should be seen as being wholly consistent with Brainard’s worldview.
With the longer-run rate currently seen at 3.0%, we can make an educated (and frankly conservative) guess that the Fed likely sees the shorter-run neutral rate somewhere near 3.5%. And this is where Powell’s comments are so jarring, as he said that rates might move above the neutral rate. That might mean somewhere in the vicinity of 3.75-4.0%. In other words, the market may be underestimating the terminal Fed Funds rate for this current tightening cycle by upwards of 100 bp.
Of course, this is all predicated on a continued economic expansion in the US. If the facts change and the economy slows, then the Fed will have no choice but to adjust its expected rate path. But for now, with growth around 4%, it’s full speed ahead with tightening. While being dollar-positive, a steeper US rate path will be very, very negative for EM, especially the debtor/deficit countries like South Africa, Turkey, Brazil, India, and many more. On the flip side, the surplus/credit countries like Korea, Singapore, and Taiwan are likely to hold up relatively better. Either way, buckle your seatbelts!