IN Amundi’s latest investment talk notes, where it discusses the Fed’s monetary policy and balance sheet reduction strategy moving forward, three key highlights were made.
Amundi is a subsidiary jointly created by Crédit Agricole and Société Générale to regroup their asset management operations.
Firstly, Amundi expects the Fed to hike rates by 25 basis points in December and to continue raising rates at a gradual pace next year. With regards to balance-sheet normalisation, there is no preset course.
The decision will largely depend on broader economic and financial conditions. If the outlook does not deteriorate, the Fed will probably decide to start the process in September.
Secondly, the initiation of the normalisation programme in September, may result in a short-term sell-off across fixed income markets, as markets digest the reduction in quantitative easing available from the Federal Reserve going forward. However, the tapering initiative has been well-telegraphed to the market so the impact should be priced in.
Thirdly, US Treasuries do not offer attractive value, relative to other fixed income sectors, given Amundi’s outlook for interest rates, and the current low level of Treasury yields.
As for the dollar, it could depreciate modestly in the near-term, as yield differentials between the US and developed markets narrow, reflecting in part the potential convergence of global central bank policy.
Amundi head of macroeconomics Didier Borowski reminds investors that core inflation has continuously remained below its long-term average since the Great Financial Crisis. Moreover, average inflation over the past eight years has fallen to its lowest level since the early 1960s.
“Even if pricing power has diminished, we maintain our view that core inflation will materialise sooner or later in an economy operating at full employment. In a nutshell, while inflation is likely to remain subdued by historic standards, at current levels, risks are clearly tilted to the upside,” says Borowski.
“Finally, potential protectionist measures from the Trump administration add to upside risks for inflation, even if these measures are now less probable than in the immediate aftermath of Trump’s election,” he adds.
Thus, Borowski expects the Fed to hike rates by 25 bps in December and to continue raising rates at a gradual pace next year. The path is clearly data dependent as the Fed needs some time to ensure that the slowdown in inflation was temporary. Because the US cycle is mainly driven by household consumption and debt, he says that the Fed does not really want to tighten monetary policy, preferring to ‘remove excessive accommodation’.
The path for the Fed funds rate will also depend on fiscal policy.
“In the run-up to the mid-term elections, we expect Congress to pass some tax cuts (in the first quarter of 2018 at the latest). While the impact on growth and inflation in 2018 is likely to be very modest, explicit support from fiscal policy would extend the duration of the cycle and give the Fed an opportunity to do more than what is currently priced in.
“While we expect two rates hikes over a 12-month horizon (including the one in December), we should not rule out three or even four rate hikes of 25 bps each next year if fiscal policy becomes more expansionary – but we’re not there yet,” said Borowski.
He believes that the Fed wants to separate its balance-sheet operations from its monetary-policy decisions. Thus he does not expect the Fed to hike rates and to start the reduction of the balance-sheet at the same FOMC meeting.
Meanwhile, Amundi portfolio manager, director of investment grade Charles Melchreit says that balance sheet normalisation may have a limited overall impact on Treasury yields in the intermediate term.
“The tapering initiative has been well-telegraphed to the market so the impact should be priced in.
That implies that the operative risk now is that Fed action on the taper does not match the market’s interpretation of its intent,” says Melchreit.
He explains that the Fed has indicated it will begin to pursue the tapering program by reducing both Treasuries and agency MBS held on its balance sheet.
“As part of their plan, they currently plan to allow Treasury maturities to run off; US Treasury maturities of 1 year or less account for approximately 13% of their Treasury holdings and a significant portion of their exposures lies in longer-term Treasuries. The Fed has flexibility regarding the maturity profile of balance sheet tapering,” he says.
This flexibility is particularly important because investors are concerned about the current flatness of the US Treasury yield curve by historical standards, and the potential for yield curve inversion, as the Fed continues to raise short-term rates.
“Whether or not this concern is justified in this time of extraordinary policy moves, but markets view an inverted yield curve as a precursor to recession,” Melchreit points out.
Thus at some point, Melchreit says that the Fed may be motivated to sell longer maturity Treasuries, to manage this inversion risk.