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What’s the Fed to Do

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Bill-LIermanSpeculation on what the Federal Reserve will do at its next few meetings (September 21st, November 2nd, December 14th) has heated up. The last couple of months the markets remained quiet but after what I would say were surprising comments from the Fed and the ECB, the markets have been put into an awkward moment. The stock market sold off along with Treasuries on September 9th. The S&P 500 declined 2.45% and the 10yr Treasury increased 7 basis points and now sits at 1.66%.

The Fed has stayed put at its 0-0.25% overnight rates since its first rate hike in December 2015. The status quo has been at the forefront and volatility in the market has been low. The VIX index, a measure of implied volatility in the equity markets reflecting the market’s estimate of future volatility, recently hit 17.5. The last time it was this high was late June.

During many speeches by the Federal Reserve Governors the last 12 months have been built around the premise that overnight rates will be low for an extended period, and any move of an increase in rates would be data dependent and well communicated.

The Federal Reserve is congressionally mandated to focus on two things; employment and price stability. Employment is strong as the unemployment rate is at 4.9%. Inflation measured by the CPI is at a frustrating low of 0.8%, however core CPI excluding food and energy registers 2.2%. Food and energy components of the CPI are volatile, therefore looking at the “core” is a way to look at underlying trends.

The Fed has pointed to other concerns while making its decisions: International events including China and most recently “Brexit”, U.S. dollar strength (a strong U.S. dollar puts downward pressure on inflation thru weak import prices), and overall stability of the markets.

The U.S. economy is on stable ground: energy prices have stabilized and wage pressures are trending up to push inflation towards the 2% target, and international headline risks have seemed to have subsided, all of which are positive for a rate hike.

The flip side is there are some events lurking to keep monetary policy at the status quo. The pesky U.S. budget concerns are on the horizon, US elections, and potential exogenous shocks to the global markets.

APCM started the year with the thought of two rate hikes, below the markets expectations of four. Currently we still hold on to one rate hike this year. It should be sooner than later as we think the September meeting is in play, however market sentiment seems to indicate December. I leave you with something I heard John Williams, Federal Reserve President of San Francisco, say at an AEDC luncheon on August 18th; it had me contemplating that a rate rise might be near:

“experience shows that an economy that runs too hot for too long can generate imbalances, ultimately leading to either excessive inflation or an economic correction and recession… If we wait too long to remove monetary accommodation, we hazard allowing these imbalances to grow, at great cost to our economy.”

Bill Lierman, CFA®
Chief Investment Officer, Fixed Income

 

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