Brian Andrew, CFA

Gaining Independence

With an 11‐year‐old boy at home, my wife and I spend a fair bit of time teaching him how to become more independent. Of course, the path to his independence is fraught with peril, and he routinely makes decisions that result in consequences which cause him to lose some of what he is trying to gain. That's part of growing up, though. It seems investors are also learning to become more independent from the effects of an easy monetary policy. Much like my son's path, this too is fraught with peril. Navigating this newfound independence will be challenging yet crucial to investors' success moving forward.

Words of Wisdom

Wednesday, the Federal Open Market Committee (the Fed's monetary policy‐making body) released the minutes from their most recent meeting, earlier this month. Investors are parsing every word in the minutes to look for signs of the Fed's future policy regarding interest rates. Most expect another interest rate hike of .25% in June, with at least one or two more after that in 2018.

The attention given these minutes and the Fed's moves are evidence that we're weaning ourselves from the dependence we had on low interest rates and monetary stimulus (known as quantitative easing – more on that in a bit). We want to take more risk alone, yet remain interested in understanding how much independence the Fed will give us.

The minutes from the most recent meeting reflected the Fed's encouragement regarding better economic growth and inflation nearer its target. The statement seemed similar to something I would say to my son as I dared him to take more risk, only in Fed speak. The FOMC noted that they “generally expected that further gradual increases in the target range for the Fed Funds rate would be consistent with solid expansion of economic activity, strong labor markets and inflation near the … two percent objective …” This is the Fed's way of saying expect us to give you more independence from our stimulative policy (i.e., higher interest rates) as long as the economy continues to improve and inflation remains near our target. So there's the rub. The ‘as long as’ gets everyone nervous in an attempt to understand what ‘solid’ and ‘strong’ mean.

Does it mean that if economic growth continues to move higher, could it remain at current levels and still be solid? As investors, we can relate to that feeling an 11‐year‐old gets when he hears his parents giving him more independence and questions just how far to take it.

For now, the answer appears to be that we will gain more independence as the FOMC noted they expect further gradual increases.

What the Market Is Saying

Bond yields provide some evidence as to how investors are feeling about the Fed's assessment of the future economy and the risk of flying with less assistance. The two‐year Treasury is a good reflection of investors' expectations for the overnight interest rate in two years. The current yield on the two‐year is near 2.5%. The Fed Funds overnight rate is now targeting a range of 1.5% to 1.75%, implying another three quarters of a percent hike in the next 24 months. However, the Fed has indicated they think that will happen by the end of the year, with additional increases in 2019. Apparently, investors are hedging the Fed's economic optimism and suggesting that it may not be as robust as it hopes.

Still, two‐year yields have risen by 1% since last summer. If economic activity does improve during the second and third quarters this year, investors may push short‐term yields even higher, providing more opportunity for bond investors interested in buying maturities between zero and five years. We believe this is the best part of the yield curve because you can currently get 80% of the yield of a 10‐year Treasury while only taking 20% of the interest rate risk (the maturity of a bond is how interest rate risk is measured). Not a common phenomenon.

While intermediate‐term yields such as the 10‐year Treasury have also risen, they remain a bit more stubborn. Again, it is possible that bond investors don't believe that the Fed will provide the independence from its stimulative policies as quickly as it has indicated.

There are those investors who are very bearish on these longer‐dated bonds, believing that interest rates will move significantly higher. They believe that as the economy continues to strengthen on the back of tax reform, better corporate earnings and the type of deregulation announced today (President Trump signed a bill that eases some of the Dodd Frank banking regulations), the Fed will be forced to raise short‐term rates more quickly than planned and intermediate and longer‐term interest rates will follow. While this may be true, we are more likely to believe that the Fed is providing some independence from its stimulative policies like we as parents would for an 11‐, 12‐ or 13‐year‐old, not a 17‐ or 18‐year‐old. And, like my wife and me, they'll get there, but it will take time.

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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.