‘Neutral’ Rate Dropping, Are Tighter Financial Conditions Finally on the Way?
- Bloomberg – Fed Neutral Rate Estimate Drops, Lowest in Over Two Years
The so-called neutral U.S. interest rate fell in the second quarter by the most since 2010, according to a widely-cited estimate produced by Federal Reserve economist Thomas Laubach and San Francisco Fed President John Williams. The theoretical rate known in economic circles as “r-star” — which is adjusted for inflation and would neither stimulate nor restrict an economy growing at its trend pace — declined to -0.22 percent, from 0.12 percent in the first quarter. In comparison, the Fed’s benchmark rate, adjusted for core inflation, is currently -0.35 percent, which suggests the central bank is nearly at a “neutral” monetary policy setting, according to the model.
- Bloomberg – Fed Balance Sheet Policy May Amount to More Easing
The structure of the bond market these days is such that there’s a good chance financial conditions will continue to loosen.
Surely that will cause long-term yields to rise and financial conditions to finally tighten, right? Maybe not. The structure of the bond market these days is such that there’s a good chance conditions will continue to loosen, further underpinning demand for riskier assets ranging from equities to high-yield debt to emerging-market currencies. To understand why, first consider that institutions that needed very high quality securities to comply with new regulations designed to make the financial system safer have been somewhat crowded out by the Fed’s purchases. They will now have the opportunity to buy Treasuries and the resulting demand should help contain long-term yields. At the same time, officials such as New York Fed President William Dudley have hinted there will be a pause in rate hikes during the initial stages of balance-sheet normalization, which should also help support the market.
ECB Likely the Most Watched Central Bank in 2018
- Reuters – Fed balance sheet plan may equal three rate hikes for emerging markets
According to calculations by IIF, one of the most authoritative trackers of global capital flows, this will slice just over $200 billion off the U.S. central bank’s balance sheet next year, assuming it keeps reinvesting some of the money for the time being. Sonja Gibbs, one of the IIF’s senior directors, also estimates that just a $65 billion drop in the Fed’s Treasury holdings would equate to a $6.5 billion to $7 billion drop in emerging market portfolio flows — bond and equity purchases by foreigners — all else being equal. “That in turn is about equal to a 25 basis point (Fed) rate hike in terms of impact,” Gibbs added.
- The Wall Street Journal – The Great Transatlantic Bond Divergence Unwind
The spread between U.S. and German bonds is narrowing, but this important indicator of global financial conditions has a long way to go
Where policy goes now is key. Markets doubt how far the Fed might get with its tightening, and seem unflustered by the prospect of the central bank shrinking its balance sheet. Investors may be too relaxed, but in the absence of fiscal stimulus and inflation, much higher yields for Treasurys might be hard to achieve in the near term. The European Central Bank, meanwhile, is set to move out of emergency-policy territory. Support for low yields on German bunds is likely to diminish as the ECB starts to move gently towards an exit from its bond purchases. While policy rates are likely to remain ultra-low for a long time to come, that implies a steeper yield curve in Germany, with the central bank exerting less influence over longer-term interest rates.
U.S. Treasuries Need a Wellness Check
- Bloomberg – Volatility Gauges Tumble to New Lows Amid Complacency Fears
Bank of America MOVE Index closes at an all-time low on Monday
The markets are alive with the sound of ‘zzzzzz’ as the latest trading session marks yet another another record low for volatility gauges. Bank of America’s MOVE Index, which gauges volatility in the U.S. Treasury market, has tumbled to an unprecedented 46.9 at the close of Monday’s trading session. The move means investors in the world’s largest bond market are shrugging off the potential for price swings, even as two titans of the industry up their bets on an uptick in U.S. inflation.