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Long Way From Neutral

Posted on October 9, 2018

“We’re a long way from neutral Fed Funds at this point...” – Fed Chairman Jerome Powell

2018-10-09_gear_shifter.jpgMonetary policy is simply not as exciting as it used to be. Long time readers of our blog might remember our four-part “Fed Ed” series which we published in the Fall of 2013 leading up to our sponsorship of a pre-screening of the documentary Money for Nothing here in Colorado Springs. In the years following, we carefully profiled the evolution of Fed policy through the quantitative easing and zero interest rate campaigns that had emerged in response to the global financial crisis. Back then monetary policy was controversial enough to be worth talking about!

But now it’s a bit more like watching paint dry. The Federal Reserve has spent most of the past several years playing a somewhat inconsequential role, no longer engaging in “money printing” and slowly but steadily lifting interest rates off the zero bound into a more normalized zone. There just hasn’t been much to talk about – and that’s probably a good thing.

That said, last week Fed Chairman Jerome Powell made a passing comment that caused the markets to sit up and take notice. The Federal Open Market Committee had recently announced its third rate hike of the year, bringing the target Fed Funds rate up to a range of 2.00-2.25% (if you’re curious what this actually means, see our post What Is A Rate Hike Anyway?). Then, last Wednesday, Chairman Powell was participating in a panel discussion with PBS News Hour’s Judy Woodruff when he made the following comments:

The really extremely accommodative low interest rates that we needed when the economy was quite weak, we don't need those anymore. They're not appropriate anymore. Interest rates are still accommodative, but we're gradually moving to a place where they will be neutral. We may go past neutral, but we're a long way from neutral at this point, probably.

While a gradual hiking cycle is fully expected and priced into the market, it was that last part of Powell’s comments that seemed to take some by surprise. What exactly does the FOMC consider to be “neutral?” How long is “a long way?” Will the glide path for future rate hikes be more aggressive than previously forecast? If so, what impact might that have on credit growth, corporate earnings, the US Dollar and financial assets? These questions and more, while not necessarily groundbreaking, have been swirling around with more energy since Powell’s comments.

As the chart below shows, after nearly seven years of holding the benchmark interest rate near zero, the march upward over the past several years has been steady and predictable. This seems to be how the market likes it. Rising, yes, but not in any sort of disruptive way.

2018-10-09_fed_funds_rate.png

But recent developments are causing more eyes to turn back to our central bankers and interest rates, as there are early warning signs that this hiking cycle is beginning to trickle through and have an impact. For one thing, long-term rates have finally decided that it’s time to rise in response to the Fed’s short-term rate hikes. The chart below reflects the change in the yield on the 10-year Treasury since the start of the Fed’s hiking cycle. Long-term yields actually fell at first, then rebounded, then drifted lower again for a while. It had been two years since the Fed began bumping the Fed Funds rate higher, and long-term yields were exactly where they were when it started. But over the past twelve months or so they have broken out to the upside in a big way.

2018-10-09_10y_treasury_yield.png

It’s important to remember that the Fed only exercises direct control over the overnight lending rate in the banking system. All other interest rates – mortgages, car loans, bond yields, credit cards, etc – are set by free market forces. As long as these other market rates were not moving higher in response to the Fed’s changes on the short end of the curve, the market had little reason to pay much attention and very little impact was felt. But now that rates of all types have begun moving up in earnest we should start to see more of a widespread reaction to the Fed’s hiking policy.

Perhaps the most significant impact higher interests will have is on housing. Several weeks ago we talked about the current state of the housing market, and how a variety of forces are playing into a downshift in growth. Key among them are higher mortgage rates which make houses less affordable, thus weakening demand and putting a damper on price and sales growth. This dynamic is slowly creeping into housing activity, but is even more pronounced in the performance of publicly-traded homebuilders (the chart below was copy and pasted from 361 Capital’s Weekly Briefing).

2018-10-09_homebuilders.jpg

Despite the variety of way in which higher rates might dampen economic growth, in our opinion continuing to increase rates is the right move and should prove to be healthy for the economy and financial markets in the long run. Besides the fact that higher rates act as an incentive to save, leaving interest rates too low for too long may drive the wrong kind of economic and investment activity – the kind that leads to excesses and bubbles. The Fed’s focus should never be on markets higher per se, but rather on employment and inflation. Both measures are currently strong and provide plenty of room for the Fed to continue raising rates. Thinking long term, when the next recession hits the Fed will want plenty of room to be able to lower rates again in and attempt to stoke economic activity.

For now, we’d agree with Powell that the interest rate environment is still accommodative on the whole, and more hiking is required in this post-crisis normalization process. How far we have to go is another question, but for the time being the financial markets will just need to get used to the idea of higher interest rates as the Fed continues shifting us back to neutral.


david_headshot_bw.jpgAuthor David Houle, CFA is a founding member of Season Investments. He serves as the firm's Chief Compliance Officer as well as sitting on the investment committee overseeing the management of client assets. David spent nearly ten years in various roles primarily managing individual client assets prior to co-founding Season Investments. David graduated with a degree in Finance from Colorado University in Colorado Springs in 2003 and earned the Chartered Financial Analyst (CFA) designation in 2006. David and his wife Mandy have three children and spend most of their free time with friends and family.


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