Wesbury’s Monday Morning Outlook article this week: Watch Reserves, Not Rates
Date: March 7, 2017
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As Washington DC melts down, entrepreneurs keep moving, people keep working and spending; the
economy keeps growing. The Federal Reserve keeps
meeting and speaking, too, but now it appears they will
actually act.
Next week’s Fed meeting (March 15th) is going to
be major news one way or another. Most analysts lean
our way and now think the Fed will raise short-term
interest rates by a quarter percentage point (25 basis
points). We laid out the case two weeks ago (Time for
a Rate Hike). If the Fed does raise rates, it will be just
the third rate hike in over a decade, but the second since
December, signaling new urgency to normalize.
However, if the Fed surprises and declines to raise
rates, despite all the hints from recent Fed speakers
including Fed Chief Yellen herself, it will also be major
news, suggesting the Fed has an unfortunate bias
against raising rates under pretty much any reasonable
conditions. We don’t think that’s likely, but it would be
big news.
Either way, investors need to focus on more than
just interest rates. Rate hikes under the current
monetary regime are different than any other time in
history. In the past, when the Fed wanted the federal
funds rate higher, it would shrink the amount of
reserves in the banking system by selling bonds to
banks and subtracting cash. With a smaller supply of
reserves, banks would bid up their cost.
But these days, there are roughly $2 trillion in
excess reserves and the Fed has no plans in motion to
reduce them. As a result, a rate hike next week would
push what the Fed pays banks on those excess reserves
to 1% from 0.75%. The idea is that if the Fed pays
higher rates, banks will continue to hold reserves and
money supply growth and inflation can be contained.
This experiment has never been tried before and no
one knows if it will work. In fact, there is good reason
to believe it won’t. An upward sloping yield curve
suggests banks have more incentive to loan as rates rise,
not less.
In other words, we will be watching the Fed’s
statement for two things. First, how quickly we can
expect interest rates to rise in the year ahead, but also
whether there are any plans to shrink the size of the
balance sheet.
Don’t blink. Things are changing rapidly. Just
nine weeks ago, the market consensus was a 31%
chance of a mid-March rate hike and only two hikes for
the year. At Friday’s close, the March rate hike odds
were 94% and that would be the first of three rate hikes
in 2017.
As these expectations changed, 10-year rates have
barely budged, closing Friday at 2.49% versus 2.45% at
the end of December. One possible reason for such a
small change in the yield is that as long as investors
think the cycle peak for short-term rates hasn’t
changed, then the average short-term rate over the next
ten years hasn’t changed much during the past few
months. So there was no reason for long-term yields to
change much, either.
The problem with this theory is that equities are
moving like investors expect faster economic growth
than the Plow Horse pace since mid-2009. In a faster
growth environment, the peak for short-term rates
should be higher, too.
We think bond investors will eventually come to
this conclusion as well. With nominal GDP growing
near 3 ½% in the past year and likely to accelerate, the
level of interest rates should rise toward that level as
well. And, even though we do not believe the size of
the Fed’s balance sheet affects long-term interest rates,
the market behaves differently. So, as the Fed signals a
faster pace of rate hikes and begins to whisper about
allowing its bond holdings (and therefore excess
reserves) to shrink, bond yields are likely to head
The bottom line is that a hike in short-rates may
not instantly set off higher long-term rates, but higher
long-term rates are headed our way anyhow. It’s just a
matter of time. #interestrates #economy #federalreserve #stockmarket#investing

Rogan & Associates


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