Investments, Trading, Treasury

Yellen and FOMC holds Fed Funds at 1-1.25%, confirms balance sheet normalisation program.

September 28, 2017

Yellen holds Fed Funds Rate at 1.00 – 1.25%: No Surprises

There were not much surprises from the FOMC decision. The content and language of the FOMC statements did not reveal much changes from the previous one in July. The few changes were,

On Job Markets:

July: Job gains have been solid, on average, since the beginning of the year, and the unemployment rate has declined.

SepJob gains have remained solid in recent months, and the unemployment rate has stayed low.

On Household Spending and Business Fixed Investments:

JulyHousehold spending and business fixed investment have continued to expand.

SepHousehold spending has been expanding at a moderate rate, and growth in business fixed investment has picked up in recent quarters

On the Hurricanes and their impact:

SepHurricanes Harvey, Irma, and Maria have devastated many communities, inflicting severe hardship. Storm-related disruptions and rebuilding will affect economic activity in the near term, but past experience suggests that the storms are unlikely to materially alter the course of the national economy over the medium term.

On Inflation:

JulyInflation on a 12-month basis is expected to remain somewhat below 2 percent in the near term but to stabilize around the Committee’s 2 percent objective over the medium term. 

SepHigher prices for gasoline and some other items in the aftermath of the hurricanes will likely boost inflation temporarily; apart from that effect, inflation on a 12-month basis is expected to remain somewhat below 2 percent in the near term but to stabilize around the Committee’s 2 percent objective over the medium term.

On Fed Balance Sheet:

JulyFor the time being, the Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction. The Committee expects to begin implementing its balance sheet normalization program relatively soon, provided that the economy evolves broadly as anticipated; this program is described in the June 2017 Addendum to the Committee’s Policy Normalization Principles and Plans.

SepIn October, the Committee will initiate the balance sheet normalization program described in the June 2017 Addendum to the Committee’s Policy Normalization Principles and Plans.

What is next? What should we expect?

The weekly chart above shows the yields of the US Treasury 10 year bonds since 2007. The lows were 1.32 levels during 2016, after which it rebounded and never quite looked back.

During 2013, the 10 year yields moved up from 1.40% levels to hit 3.04%. This was when the official Fed Funds Rates were still zero, and even before Fed made its first hike in Dec 2015! On hindsight, we now know why market sold the Treasuries off due to better numbers from US, portfolio diversification, Fed tapering and etc. The differential between 10 year and FFR was about 3.00%!

Now that Fed Funds Rates are at 1.00% – 1.25%, the long term yields are trading around 2.34%. The gap between 10 year UST and FFR is only 1.10%. What is so different between now and 2013? Have inflation levels dropped significantly, unemployment levels skyrocketed or other macro indicators worsened?

Or has market expectations changed dramatically?

Any serious market watcher or macroeconomics student are aware that long term interest rates are influenced by multiple factors; underlying base rate, inflation levels, growth rates, etc etc etc…, and market expectations.

Base rate, inflation, growth rates, prices and other factors can be easily quantifiable, but not market expectations.

How do you quantify expectations? How do you measure it, and what do you factor in, are there any proxies? (I’m not a qualified quant nor am an accomplished mathematician, and will be happy if anyone of you could write in, share and demystified the arcane financial engineering behind it.)

My view is that the era of low interest rates is over. ZIRP is a thing of the last decade. Unless that Bond traders are anticipating something that we do not know, I think the long term yields are too low and the market is not pricing in the future now.

Maybe they are just being wary of North Korea, skeptical of Trump, concerned about equity markets being over-valued (which is a contentious issue anyway) or they are just unsure about Fed’s normalisation and its side effects or just uncertain where Fed will be heading after Yellen.

What do you think?

 

about author

Seng Ti is currently heading a Treasury & Finance team in a MNC and is active in the Corporate Treasury scene. He enjoys reading and discussing about current affairs, politics, life, wine and lives a normal life with his wife and 2 young kids.