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Connect the dots

ED GOARD, CFA 02-Dec-2018

Decoding the macro picture is not always easy. The domestic economy is humming, no doubt about it, but geopolitical risks continue to linger over financial markets. The U.S. dollar remains strong, but that’s also creating headwinds for some emerging markets investors. And although an all-out global trade war appears less likely given the recent agreements reached with Mexico and Canada, the U.S. - Chinese trade relationship seems to be deteriorating by the day. 

All these cross-currents make for a tricky environment, and many fixed income investors are not quite sure what influences will take precedent. For clues, we might look to see how the Federal Reserve is connecting the dots—or should we say “dot plots.”

For those investors not as wonky as us, the dot plot is an unofficial Fed tool that’s typically released with the Federal Reserve’s FOMC statement. It simply shows how members are assessing monetary policy and where each member believes the fed fund rate should be in the future. After executing its third rate hike of 2018 at the September policy meeting, consistent with their published forecast, the FOMC updated its dot plots, revealing that 12 of the 16 members were forecasting a fourth increase this year.

This is an outcome many investors were skeptical of at the beginning of 2018. The committee also removed the “accommodative” characterization of policy in the September release, yet Chairman Powell was quick to communicate that this did not signal a change on the policy path but rather an unknown as to where policy becomes restrictive in the current cycle.  

In other words, the arrow for rates is still pointing upwards. The committee continues to see three increases in 2019 and one in 2020, consistent with last quarter. Interestingly, the September forecast included the first look at 2021, which is flat to its view of 2020, implying the committee, on average, does not anticipate it will be in easing mode three years out.  

Although that’s a long way away, the FOMC’s expectation seems to be that growth moderates back into the 2.0-2.5% over the next several years, coupled with inflation hovering around the 2.0% target, thus remaining on the gradual path of rate increases as advertised. The tightness of the labor market and potential for tariffs and/or stronger wage growth are worth monitoring closely as this could alter that outlook and the rate path.  

Although the overall growth outlook for the economy remains favorable over the near-term, a tightening in credit spreads in the third quarter and the flatness of the yield curve have prompted us to maintain a relatively cautious view on risk. The FOMC is tightening monetary policy using two tools: 1) by raising short term interest rates, and 2) by shrinking its balance sheet, (allowing holdings of U.S. Treasuries and Agency Mortgages to shrink by up to a maximum of $50 billion per month, which in turn shrinks money supply). If the FOMC continues this two-track tightening of monetary policy with three additional increases in 2019 as it is currently telegraphing, it will likely invert the yield curve. Normally, this leads to underperformance in credit spreads. That’s a legitimate policy risk that bears watching, and thus we will continue to carefully manage yield curve positioning and duration within our portfolios based upon how we connect our own proprietary dots.