Trusted performance.  Lasting value.

Recent global economic and political turmoil leads to doubt about forecasts from Federal Reserve officials — and most Wall Street economists — that the Fed will begin to lift its benchmark interest rates in mid-2015

Oct 28, 2014

By Bloomberg News

Investors eyeing recent global economic and political turmoil are expressing doubt about forecasts from Federal Reserve officials — and most Wall Street economists — that the Fed will begin to lift its benchmark interest rates in mid-2015.

The Federal Open Market Committee meets Tuesday and Wednesday after six weeks of volatility in global financial markets. Chair Janet Yellen and her colleagues will focus instead on a robust U.S. outlook and end their bond-buying program as planned, according to 62 of 64 economists surveyed by Bloomberg News. By smaller margins, most also expect the FOMC to reiterate rates will stay low for a “considerable time” and that there’s a “significant underutilization of labor resources.”

Since the FOMC met in mid-September, oil prices have tumbled 14%, the S&P 500 Index dropped as much as 7.4% from a record close and yields on 10-year Treasury notes touched the lowest since May 2013. The retrenchment has widened a gulf between Fed officials and a majority of private economists on one side, who see the next tightening by mid-2015, and investors who say rates will stay at record lows for longer.

“The Fed is certainly going to consider the turmoil we have seen in recent weeks,” said Dana Saporta, director of U.S. economic research at Credit Suisse Group AG in New York, whose firm expects the quantitative easing program to end at this meeting. “But ultimately we think they will stay the course and the first tightening will come in the middle of next year.”

DUDLEY AGREES

Fed district bank presidents William C. Dudley of New York and John Williams of San Francisco earlier this month called such estimates reasonable. Economists in the Oct. 22-24 Bloomberg survey agreed, with 52% predicting the FOMC will raise the benchmark interest rate in the second quarter of 2015.

Fed officials’ September forecasts showed a median funds rate estimate of 1.375% at the end of next year. One scenario to reach that outcome would be rate rises starting midyear in quarter-point steps over the following several meetings.

Contradicting that view are U.S. money markets, where investors are betting on a later tightening. Futures contracts show an 85% probability that the Fed’s policy rate will be no higher than 0.25% in June 2015. Sixty-four percent see it at 0.5% or higher in December of that year.

Concern over the spread of the Ebola virus, low inflation in developed economies, resurgent violence in the Middle East and stagnating euro-area growth have all caused investors to put more weight on the possibility of a later rate rise next year, said Lou Crandall, chief economist at Wrightson ICAP.

“Markets have seen a lot of things they don’t fully understand over the past three or four weeks,” said Mr. Crandall, who is forecasting a June rate increase.

A large minority of economists in the survey share that view. Forty-one percent said the first rate increase would happen in the third quarter or later. Eight percent said it would occur in the first quarter of 2015.

Despite global challenges, most economists forecast the U.S. economy will expand 3% next year, bringing unemployment down to an average rate of 5.5% in the fourth quarter of 2015, according to a separate Bloomberg News survey Oct. 3-8. That’s at the top end of Fed officials’ estimated range for full employment. The jobless rate was 5.9% in September.

MORE ‘UNCERTAINTY’

“The baseline outlook looks the same, but the uncertainty around the baseline has increased” and short-term rate markets are pricing accordingly, said Michael Gapen, senior U.S. economist at Barclays Capital Inc. and a former member of the Fed board staff. Barclays forecasts a June rate increase “with risks” that it happens in September, Mr. Gapen said.

Yield differences between Treasury notes and U.S. government inflation-linked bonds show investors now expect inflation to average 1.5% over the next five years compared with 1.81% on Sept. 16.

St. Louis Fed President James Bullard said in an interview Oct. 16 that it would be a “logical policy response” to delay the end of quantitative easing to boost inflation expectations. Economists in the survey gave an extension of quantitative easing only a 3% probability.

Lower commodity prices due to a weaker global growth outlook are the primary reason expectations for U.S. inflation have moved lower in market measures, according to 71% of economists polled.

Actual inflation, measured by the personal consumption expenditures price index, has remained below the Fed’s 2% target for 28 months, with prices rising just 1.5% for the 12 months through August.

Seventy-two percent of economists in the survey said the price index won’t show a third consecutive reading of 2% or higher until the fourth quarter of 2015 or later.

Even so, 53% said the Fed will leave its phrasing on inflation unchanged from September. At that time, the FOMC said the “likelihood of inflation running persistently below 2% has diminished somewhat since early this year.”

Thirty-six percent of economists said the Fed will revert to language used mid-year, that inflation “persistently below” the 2% target “could pose risks to economic performance.”

Eighty percent of economists said the Fed will continue say it will be appropriate to hold the federal funds rate between zero and 0.25% for a “considerable time.”

Among them is Ryan Sweet, a senior economist at Moody’s Analytics. The drop in oil prices will help offset a weaker world economy, he said.

“There are a lot of crosscurrents, but what really matters for the course of QE is what it means for growth,” Mr.Sweet said. “All the events over the past few weeks are neutral to a slight positive for GDP.”

Oct 14, 2014

By Bob Michele

A lot of downside risk in fixed income has been removed and investors should take advantage of strong investment opportunities that have formed in the bond market

Patient bond investors have been rewarded in 2014. A zero interest rate policy around the world and low volatility are forcing cash into bond markets, continuing to hold down government bond yields and bolster risk assets.

It would seem this is proof of the old dictum ‘Don’t fight the Fed.’ For investors, that applies as well to the European Central Bank, the Bank of England and the Bank of Japan, all of whom have pursued coordinated unconventional intervention to pump liquidity into global markets.

There are few signs to suggest that this dynamic is going to dramatically shift anytime soon. In our view, the sub-trend economic recovery will continue in 2015, with global GDP growth averaging between 2 and 4% and global inflation remaining benign between 0 and 2%. Central banks will continue to provide the necessary liquidity until they see broader economic strength and/or material wage inflation, although the balance of that transition for the US Fed will be closely watched.

We expect the Federal Reserve will move to raise the fed funds rate in mid-2015 and that may be a test for the bond markets as the opportunity for profit taking arises. That said, the Fed is well aware of the potential risk of the first rate increase in eight years and will proceed carefully with normalization.

Given the amount of liquidity central banks have pumped into the system and the resulting stability it has created, a lot of the downside risk has been removed — investors should take advantage of these strong investment opportunities that have formed within the bond market.

KEEP IN PERSPECTIVE

Investors have to keep record low government bond yields in relative perspective, especially in the case of U.S. Treasuries which currently offer marginally better returns than many other sovereign bonds. There is only so long investors can sit in cash earning a 0% return in the U.S. — perhaps a negative yield in Europe — before bonds prove to be a more desirable weighting.

We continue to like high yield bonds, where credit spreads look attractive. The sector should continue to benefit from low default rates and the investor search for yield. We continue to like corporate credit where companies are acting as prudent borrowers and doing a good job managing their balance sheets.

In terms of the investment implications, today’s environment underscores a trend we’ve been seeing for some time that is quickly gaining momentum: a shift from traditional, benchmark-oriented fixed income strategies to more benchmark-agnostic, flexible approaches.

The ability to shift irrespective of a benchmark allows managers to be nimble in adjusting sector and duration exposure in response to changing market conditions. These next generation unconstrained bond strategies are free to seek out the most attractive risk-adjusted return opportunities whilst maintaining the characteristics of a bond portfolio. Rising flows in recent years to this category would suggest investors believe they are likely better suited for today’s uncertain bond investing landscape. This may be particularly relevant around the market’s next big test as it looks ahead to the first Fed funds rate increase.

Bob Michele is CIO and head of global fixed income, currency & commodities at J.P. Morgan Asset Management