Brian Andrew, CFA

Doves, Hawks and Robins

Spring is here! Unless of course you are living through your 4th nor'easter in the last month, in which case you'll have to wait. Here in Wisconsin, robins are back in the yard. Yesterday's news from the Federal Reserve Bank came with an increase in interest rates and a debate about whether it is becoming more hawkish or dovish. Let's sort out the bird talk and see what it means for bond and stock investors.

Fed's Announcement

With the end of its Federal Reserve Open Market Committee (FOMC) meeting yesterday, the Fed raised interest rates by .25%. The new range is between 1.5% and 1.75%. In addition, it projected that rates would rise three more times this year, three times next year and twice more in 2020. Seven members voted for four hikes in 2018 – up from three last time. The reason for the change seemed to be the Fed's perception that economic growth could be faster this year.

It raised its forecast for real economic growth by .3%. It also lowered its unemployment rate call to 3.8% in 2018 and 3.6% in 2019, reflecting its belief that more growth will lead to a lower unemployment rate (we're currently at 4.1%).

Finally, the Fed indicated that it thought inflation would be slightly higher going forward due to faster growth. Its estimate for 2018 and 2019 is 2 to 2.1%.

The bond market reacted immediately with 10‐year Treasury yields rising by almost .1%. However, this morning, yields declined again and stood just slightly above where they were before the announcement. Stock indexes initially rallied by .5% to .75% and then slowly traded back down, finishing the day lower. This see‐saw reaction on the part of markets is a reflection of how some investors viewed the announcement as hawkish and some dovish.

The Hawkish View

Clearly the Fed and its new Chairman, Jerome Powell, believe the tax reform we received at the end of last year, along with an increase in the deregulatory nature of Washington will lead to faster growth in 2018. Faster growth usually leads to higher inflation, which causes the Fed to raise interest rates.

By forecasting higher economic growth and inflation for the next several years, some believed the Fed was signaling a desire to push interest rates higher at a faster pace. And it said as much with the average of FOMC members' forecasts rising by .125% to .25% over the next couple of years. Still these changes are very modest and it might be an overstatement to talk about a more hawkish Fed.

We use the term “hawkish” to imply that Fed members are more worried about growth pushing inflation above their target. As a result, they will use raptor like vision to watch for any signs that inflation could move above their target and ultimately provide less help. Less help means more interest rate hikes and so bond investors initially may have reacted to this view when they sold off the bond market yesterday afternoon. After some consideration, more time to digest the Fed Chair's speech and answers during the Q&A session, a different opinion emerged.

The Dovish View

After they had digested the Fed's statements and view, bond market investors seemed to come to the conclusion that its policy hadn't changed much. And that is more likely the right perspective. While it recognized slightly faster growth, its estimate is still below 3%. It acknowledged that inflation may be higher but its estimate is only slightly above its target.

In addition, the Fed's estimate and statements seem to suggest that while we'll see some benefit from tax reform in 2018, the longer‐term effects may be more muted and be fighting the headwinds of higher wage growth. This means that those two things may offset one another. As a result, its long‐range forecast for the Fed Funds rate is perceived by some to be too aggressive.

We are entering the 10th year of an economic recovery. We have seen intermediate interest rates go from a low of 1.4% in 2016 to 2.9% today. When rates rise by 1.5%, it almost certainly will lead to slower economic growth, meaning less inflation pressure. It is important to note however, that the majority of this increase took place in late 2016 and early 2017. Relative to where intermediate‐term interest rates were at the beginning of last year, they are only slightly higher.

To be sure, the Fed is aware of the fact that its own market activity will lead to higher short‐term interest rates. In fact, the 2‐year Treasury yield, a good predictor of future Fed activity, now stands near 2.3% after rising as high as 2.36% yesterday. This rate is over 1% higher than it was last summer reflecting the work of the Fed to raise rates.

Short‐term investors will continue to benefit from the Fed's activity. In fact, we now see bond investments with a half year average maturity providing better than a 2% yield. (I know for those with long memories that isn't much but it is better than 0%!).

The dovish view (meaning a slower pace of hikes) then, seems to suggest that while growth will be slightly better, and inflation slightly higher, we are not on pace to see real growth accelerate dramatically. In fact, the higher yields will begin to have a dampening effect and that may be why the Fed's own estimates didn't grow by more.

As the Fed says, we are all “data dependent.” That means only time will tell what happens. For our money we believe that bond investors should continue to own the shorter end of the yield curve (i.e., less than 5 years) as the benefits of cash flow reinvestment and Fed hikes will lead to better returns than longer‐term bonds where rates may not move at all or slowly grind higher.

Stock investors will be stuck with some additional volatility as the air war between hawks and doves takes place.

As for the robins, they will certainly continue to move back into the neighborhood as harbingers of warmer days. That certainty provides some solace from an uncertain market environment.

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Views and comments expressed in this blog are those of the author and do not necessarily represent the positions of Cleary Gull or fellow Cleary Gull associates.