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Sometimes It's Easy


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“Plain question and plain answer make the shortest road out of most perplexities” – Mark Twain

We seem to have reached a clear “quo vadis” (“which way”) moment with interest rates in 2017. On the one hand, the Federal Reserve (Fed) seems quite sanguine in their assessment of projected economic growth and financial conditions. Most district presidents and Board governors believe that inflation goals have essentially been met, and the labor market is potentially at risk of overshooting full employment. The Fed seems pretty confident that at least two more fund hikes are achievable in 2017, along with tapering reinvestment of their $4.5 trillion balance sheet in either late 2017 or early 2018. This tapering will serve as stealth tightenings since declines in reinvestment reduce the money supply and excess bank reserves at the Fed.

On the other hand, the interest rate markets are far less confident than the Fed, as illustrated by what has happened to rates and the futures markets in a little over a month. On March 14, the day before the last Federal Open Market Committee meeting, the 2-year Treasury note yielded 1.37%, and the Fed Funds Futures market solidly predicted that the Fed would raise the Funds rate three or four times (including the March 15 meeting) in 2017. Now, after a spate of weaker than expected economic data releases and rising geopolitical tensions, the 2-year note yields 1.18% and the Fed Funds Futures market predicts only one more Funds rate hike for the remainder of 2017.

Luckily for us, Goldman Sachs Chief Economist, Jan Hatzius, was interviewed by CNBC and teed up the questions we must ask ourselves as we ponder the path the Fed will take for the rest of 2017. “Market pricing of future Fed rate hikes has declined in the wake of weaker GDP and inflation data, signals of an earlier Fed balance sheet runoff and reduced optimism on fiscal easing,” Jan Hatzius, chief economist at Goldman Sachs, said in a note. “But markets may be underestimating three factors pointing toward continued steady hikes.” Specifically, Hatzius cites easing financial conditions, continued optimism that the Trump agenda will be put into action at some point and a tightening labor market that will push the Fed to act.

Therefore, I believe that if we look at the three points Mr. Hatzius makes, we can arrive at three important questions we should consider:

  • Will the Trump pro-growth agenda pass in 2017?

  • Will financial conditions ease?

  • Will the labor market continue to tighten?

If the president and Congress can still deliver on healthcare and tax reform this year, and we experience either financial conditions easing or labor markets tightening, the odds of the Fed increasing the fund rate at least two more times in 2017 (making it three for the year, the consensus goal for the committee for 2017) are very good. Therefore, if you feel this could happen, prepare for rates to reverse this latest rally and increase back to their mid-March levels (approximately 1.35% on 2-year, 1.75% on 5-year and 2.60% on 10-year).

However, if you have doubts that pro-growth legislation can be enacted, most notably tax reform, in 2017, and you believe that increasing consumer debt delinquency rates (specifically auto loan debt) can work to tighten financial conditions as we progress through 2017, I think you side with the Fed raising the funds rate perhaps one more time or not at all in 2017. If this is the case, then the rally that we are currently experiencing will continue with the yield curve continuing to flatten.

Moreover, one major thing that Mr. Haztius left out was the effect geopolitical risks can have on the president’s legislative agenda and the global economy. If you add these concerns to the mix, it is quite possible that the time and attention the administration is giving to domestic initiatives could be diverted, thus hindering legislative progress. The geopolitical factor has me leaning pretty strongly toward lower rates and a flatter yield curve.

Oddly, in an increasingly complex world, the questions we must ask ourselves are, in my opinion, pretty plain, as are the answers. Ask yourself these questions:

  • Will the Trump pro-growth agenda pass in 2017?

  • Will financial conditions ease?

  • Will the labor market continue to tighten?

Based on your answers, your view on interest rates will become very clear.

Member SIPC & FINRA. Advisory services offered through SWBC Investment Company, a Registered Investment Advisor.

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