Over the course of the week a number of Fed speakers have taken to the wires. Perhaps one of the more interesting speeches was from William Dudley, the New York Fed President, who spoke yesterday on ‘The importance of Financial Conditions in the Conduct of Monetary policy.’ This is of interest as while the Fed has increased the Fed Funds Rate by a total of 50 bps since December 2016 ‘financial conditions’ in the marketplace have eased to offset this. For Dudley there are ‘five key measures: short- and long-term Treasury rates, credit spreads, the foreign exchange value of the dollar, and equity prices.’ For example, the US Dollar Index has retraced close to half the gains made since the election of Donald Trump.
Dudley noted the improvement in the economy and that the risks to ‘growth and inflation over the medium to longer term may be shifting gradually to the upside’ whereas Janet Yellen and the FOMC statement had talked about the near-term risks as being ‘roughly balanced’. While seeing financial conditions as an important factor to consider in monetary policy setting he noted that the Fed was focused on its dual objectives of maximising employment and price stability and he stated ‘it is also important not to overreact to every short-term wiggle in financial markets.’ Touching on the issue of reinvestment and the Fed Balance Sheet he noted ‘Presumably, financial conditions would tighten by more if we were to end reinvestments earlier and more abruptly. This suggests a better course may be to taper reinvestments gradually and predictably.’ For Dudley tapering would also need to be factored into interest rate decisions: ‘I would expect that, when we begin to end reinvestment, we will have to consider the implications for the appropriate short-term interest rate trajectory.’
For us June looks to be very much a live meeting for another rate rise. Barring any slowdown in the economic data points, we would expect the Fed to continue with two additional 25 basis point hikes as the year progresses. That said, our proprietary models suggest that the 10 year US Treasury yield at 2.42% is already discounting this. Predicting the path of interest rates in the US beyond that is difficult without more detail on Donald Trump’s policies and knowing what he can get approved by congress, particularly in light of last week’s back-down over Trump’s Health Care Act in its current form.
Our view remains that the yield curve will flatten and we favour positioning at the long end of the yield curve. Even if the Fed were to pursue a more aggressive interest rate path advocated by more hawkish members this would benefit our longer dated exposure, unless it is due to inflation accelerating, but we see this as unlikely.
But perhaps one interesting point to consider is the potential for change in the FOMC’s voting members: there are already two spaces on the voting committee that Donald Trump can nominate candidates for which must then be confirmed by the senate. Plus, Governor Tarullo is due to depart in April and Janet Yellen’s term ends at the end of January 2018.
In terms of credit, while spreads in investment grade credit may not tighten significantly from current levels we still see scope for valuation upside by targeting undervalued credits with several notches of credit cushioning versus their rating and which trade on attractive positive yields. For example, this week Gazprom issued a £850m 7 year sterling bond on a 4.25% yield which on a best rating (BBB- Fitch) basis is trading over 3 credit notches cheap on our models.