by
Molly Musler
| Feb 21, 2017
While the media has recently focused on the increased selling of U.S. Treasuries by foreigners, we thought it would be timely to address these concerns and provide a broad overview on our thoughts regarding interest rates. After raising interest rates only once in each of the past two years, we believe a recovery in corporate earnings, increased wage inflation and an increase in fiscal spending will drive the Federal Reserve to raise the fed funds rates more than once in 2017.
The current media narrative would have investors believe that foreign investors are afraid that U.S. stimulus will lead to rising inflation and bigger deficits. With foreigners holding approximately 43% of U.S. government debt, investors fear that policy missteps by the U.S. could lead to foreign retaliation through aggressive selling of U.S. Treasuries. While this dystopian scenario can’t be ruled out, it’s highly unlikely. Under most scenarios, the U.S. Treasury yield will increase only gradually in 2017.
If you look at the change in Treasury holdings, it reveals that China is by far the most active seller, with the selling largely attributed to the country’s own efforts to stem capital outflows and to prevent a rapid depreciation of its currency. There is a leadership transition later this year in China, and policy makers are trying their utmost to prevent the economy from wobbling. Both China and Japan are selling for unique reasons tied to stabilizing their economies.
After hitting a high of close to 2.60% in the middle of December, the 10-year Treasury yield has retreated, with the 10-year Treasury currently yielding 2.45%. After Federal Reserve Chair Janet Yellen’s Humphrey-Hawkins testimony to Congress on February 14, and combined with stronger than expected CPI inflation, the probability of three rate hikes this year has increased to nearly 40%. Bigger picture, bond yields remain close to 140 year lows and, prospectively, yields will likely adjust upward.
Post-election, President Trump has spent political capital on several initiatives away from tax reform, deregulation and infrastructure spending. These efforts, including those tied to immigration and repealing the Affordable Care Act, at the very least will postpone the effects of a Trump stimulus plan. Furthermore, while the market remains ebullient that government spending will jump start the economy, there is skepticism over the size and scale of a stimulus package. Due to the president’s pursuit of other agendas, passage of a stimulus package will likely be postponed to the end of this year if not until 2018.
Furthermore, GDP bears closer resemblance to a tanker than a speedboat. GDP growth will remain constrained by both demographics and productivity, neither of which can turn on a dime. Specifically, the combination of greying demographics and sub 2% annual productivity growth acts as restrictor plates on GDP growth. While the economic upswing that began at the end of last year has gained momentum into 2017, stronger economic activity will be constrained by these secular factors. Concerns that a sharp acceleration in GDP growth could lead to the Federal Reserve raising rates at a frantic pace are likely unfounded.
While we continue to believe that we are in store for more rate hikes, we also believe the Federal Reserve will remain data dependent and the pace of hikes will be measured and well telegraphed. Recent chatter has increased regarding selling the Federal Reserve’s $4.5 trillion holdings of government bonds, which could cause interest rates to spike higher. In her Humphrey-Hawkins testimony, Chair Yellen indicated she would focus on reestablishing interest rates as an instrument in the Federal Reserve’s toolkit. Historically, the Federal Reserve has been able to cut rates to accommodate a weakening economy. To cut rates in times of economic weakness, interest rates must be raised to a sufficiently high level to provide room for future cuts. Selling bonds held by the Federal Reserve is unlikely to be a 2017 event. A decision to shrink the Fed balance sheet will likely be well broadcasted given the Fed’s recent experience with the “taper tantrum.” Recall in Spring 2013 investors panicked when the Fed announced it would likely start slowing down the pace of bond purchases later in 2013. Overall, we expect the Federal Reserve will continue to act in a methodical and deliberate fashion.
In summary, we believe the fed funds rate will likely rise for the remainder of the year, with between two to three rate hikes in 2017, yet, under most scenarios, we do not believe the path will be a steep spike upward.
