The surprising FOMC decision to continue QE at an $85 billion a month pace convinced investors to fully embrace for
now the Fed’s dovish rate guidance through 2016, supporting a substantial repricing of the medium-term fed funds
rate outlook and strong corresponding 7-year-led gains in Treasuries to the lowest yields in five weeks. It’s not clear
that QE itself is broadly so important at this point – although the MBS market did rip higher with the New York Fed
expected to be buying up nearly 100% of gross supply – but the signaling effect on the rate outlook from the decision
to surprise a clear investor consensus on tapering was more powerful than any adjustments to the Evans rule
thresholds likely would have been. The FOMC’s projections that the economy will be at full employment at the end of
2016, the inflation rate will be near the 2% target, but that the nominal fed funds rate will only be at 2% (and the real
rate thus near zero) are hard to reconcile, but the signal from the QE tapering surprise drove the market to fully
embrace that projection, with eurodollar futures moving into line with a 2% end 2016 overnight rate, and the timing
priced for the first hike shifting out to mid from early 2015. So with the QE surprise, the Fed was able to fully achieve,
for now at least, pretty much complete market acceptance of its rate guidance after what had been increasing
challenges by investors to not only Fed guidance but, more so, rate guidance from the Bank of England and ECB.
As far as where we go from here, we thought we understood the Fed’s thinking on diminishing benefits of ongoing QE
versus rising costs and risks, and we thought we basically understood their reaction function to incoming data after
what had seemed to be increasingly clear guidance on QE tapering plans since May. Clearly that ended up being
wrong, and at this point we have no clarity on what might drive a decision to move forward with QE tapering at the
October or subsequent FOMC meetings. The FOMC statement highlighted risks from tightening financial conditions –
“the tightening of financial conditions observed in recent months, if sustained, could slow the pace of improvement in
the economy and labor market” – which raised the question, What tightening in financial conditions? Looking broadly,
there hasn’t been any of any significance that we can see. Sure, there’s been a significant rise in mortgage rates, but
risk assets are at record highs, the Fed’s broad trade-weighted dollar index hasn’t moved much (up about 2.5% since
the recent lows in early May), lending conditions have continued to ease, and heavy demand for record corporate and
SSA issuance has clearly demonstrated that capital market conditions remain highly accommodative and supportive
of growth. At his press conference, Chairman Bernanke indicated that in addition to concerns they had about
financial conditions, generally the Fed wanted to see more data confirming its forecast for a sustained pick up in
growth before starting to scale back QE – “We're looking again to see confirmation of our broader scenario, which
basically is that we'll continue to see progress in the labor market, the growth will be sufficient to support that progress,
and that inflation will be moving back towards target. And that's what will determine our policy decisions.”
At this point who knows what that means specifically in terms of near-term incoming data looking ahead to the
October 29-30 and December 17-18 FOMC meetings. We don’t have any good sense of what the Fed’s reaction
function is at this point, so our initial baseline is flip a coin on QE tapering at upcoming meetings. One thing to keep
in mind as a potentially increasingly important consideration for policy decisions may be Vice Chairman Yellen
effectively taking more of the lead even before Chairman Bernanke steps down early next year. According to the
Washington Post, White House officials are signaling that she is likely to be nominated to succeed him, and the
announcement could come next week (“Yellen most likely to get Fed chairmanship, official says”).
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now the Fed’s dovish rate guidance through 2016, supporting a substantial repricing of the medium-term fed funds
rate outlook and strong corresponding 7-year-led gains in Treasuries to the lowest yields in five weeks. It’s not clear
that QE itself is broadly so important at this point – although the MBS market did rip higher with the New York Fed
expected to be buying up nearly 100% of gross supply – but the signaling effect on the rate outlook from the decision
to surprise a clear investor consensus on tapering was more powerful than any adjustments to the Evans rule
thresholds likely would have been. The FOMC’s projections that the economy will be at full employment at the end of
2016, the inflation rate will be near the 2% target, but that the nominal fed funds rate will only be at 2% (and the real
rate thus near zero) are hard to reconcile, but the signal from the QE tapering surprise drove the market to fully
embrace that projection, with eurodollar futures moving into line with a 2% end 2016 overnight rate, and the timing
priced for the first hike shifting out to mid from early 2015. So with the QE surprise, the Fed was able to fully achieve,
for now at least, pretty much complete market acceptance of its rate guidance after what had been increasing
challenges by investors to not only Fed guidance but, more so, rate guidance from the Bank of England and ECB.
As far as where we go from here, we thought we understood the Fed’s thinking on diminishing benefits of ongoing QE
versus rising costs and risks, and we thought we basically understood their reaction function to incoming data after
what had seemed to be increasingly clear guidance on QE tapering plans since May. Clearly that ended up being
wrong, and at this point we have no clarity on what might drive a decision to move forward with QE tapering at the
October or subsequent FOMC meetings. The FOMC statement highlighted risks from tightening financial conditions –
“the tightening of financial conditions observed in recent months, if sustained, could slow the pace of improvement in
the economy and labor market” – which raised the question, What tightening in financial conditions? Looking broadly,
there hasn’t been any of any significance that we can see. Sure, there’s been a significant rise in mortgage rates, but
risk assets are at record highs, the Fed’s broad trade-weighted dollar index hasn’t moved much (up about 2.5% since
the recent lows in early May), lending conditions have continued to ease, and heavy demand for record corporate and
SSA issuance has clearly demonstrated that capital market conditions remain highly accommodative and supportive
of growth. At his press conference, Chairman Bernanke indicated that in addition to concerns they had about
financial conditions, generally the Fed wanted to see more data confirming its forecast for a sustained pick up in
growth before starting to scale back QE – “We're looking again to see confirmation of our broader scenario, which
basically is that we'll continue to see progress in the labor market, the growth will be sufficient to support that progress,
and that inflation will be moving back towards target. And that's what will determine our policy decisions.”
At this point who knows what that means specifically in terms of near-term incoming data looking ahead to the
October 29-30 and December 17-18 FOMC meetings. We don’t have any good sense of what the Fed’s reaction
function is at this point, so our initial baseline is flip a coin on QE tapering at upcoming meetings. One thing to keep
in mind as a potentially increasingly important consideration for policy decisions may be Vice Chairman Yellen
effectively taking more of the lead even before Chairman Bernanke steps down early next year. According to the
Washington Post, White House officials are signaling that she is likely to be nominated to succeed him, and the
announcement could come next week (“Yellen most likely to get Fed chairmanship, official says”).
The extension of the FOMC’s forecasts to 2016 in the Summary of Economic Projections showed, as expected, what appeared to
us to be a wide inconsistency between the economic and interest rate forecasts. The central tendency projections show the
unemployment rate falling from a 6.4% to 6.8% range in 2014Q4 – hitting the 6.5% Evans rule threshold either in late 2014 or early
2015 in most FOMC members’ forecasts – to a 5.9% to 6.2% range in 2015Q4 and to a 5.4% to 5.9% range in 2016Q4. The
2016Q4 forecast falls right on top of the FOMC’s long-run full employment estimated range of 5.2% to 5.8%. Inflation, meanwhile,
is expected to continue gradually drifting higher to end 2016 a bit below but close to the 2% target, with a central tendency range for
the 2016Q4 year/year change at 1.7% to 2.0% for headline PCE and 1.9% to 2.0% for the core. With the economy expected to be
at full employment by late 2016 and the inflation rate expected to be close to target, any formulation of a standard forward-looking
Taylor rule and any optimal control variation of the Taylor rule (which deals with how to approach misses from full employment and
target inflation but doesn’t say to act differently once the targets are achieved) would put the fed funds rate close to the long-run
neutral level, which the FOMC continues to estimate at 4%. Instead FOMC participants forecast that under an “appropriate pace of
policy firming” the fed funds rate would end 2016 at a median 2% and a mean 2.26%, up from a (little changed) projected end 2015
median rate of 1% and mean of 1.25%.
Chairman Bernanke’s explanation for this 2016 economic and rate forecasts divergence in his press conference didn’t seem
consistent with the Fed’s own forecasts. He said that “there may be possibly several reasons” for the end 2016 fed funds rate
expectation being still far below the long-run neutral level, but the “primary reason for that low value is that we expect that a number
of factors, including the slow recovery of the housing sector, continued fiscal drag, perhaps continued effects from the financial
crisis, may still prove to be headwinds to the recovery. And even though we can achieve full employment, doing so will be done by
using rates lower than sort of the long-run normal.” He said these major lingering headwinds meant it might take “another two or
three years after 2016 to ultimately get to 4%.” In “economics terms, the equilibrium rate, the rate that achieves full employment,
looks like it will be lower for a time because of these headwinds that will be slowing aggregate demand growth. So that's why we
expect to see rates at unusually low levels.”
But that explanation based on sustained damage to the economy’s potential output has not appeared in any way to be reflected in
the FOMC’s actual forecasts now or at any time since the crisis. The Fed’s optimistic growth estimates for the next few years –
median real GDP growth forecasts of 3.0% in 2014, 3.25% in 2015, and 2.9% in 2016 – that are expected to drive the labor market
to full employment within three years and their steady 2.2% to 2.5% long-run potential GDP forecast range continue to suggest that
the Fed does not view the financial crisis as having done any lasting damage to the level or growth rate of potential GDP. Indeed,
forecasts that have appeared to stubbornly refuse to concede damage to the economy’s potential from the crisis have characterized
the SEP projections consistently since the recession ended, though this has become somewhat less pronounced after several
years of serial disappointments of very upbeat projections (4% GDP growth this year was expected by the FOMC in early 2011!).
With no signs in the forecasts of lasting damage to the level or growth rate of output from the crisis and persistently above-trend
growth expected for several years, how is the economy seen as being still so badly hobbled at the end of 2016 by financial crisis
hangovers that the neutral real fed funds rate at that point is zero percent? In our view, the Fed’s 2016 SEP projections are not
consistent or ultimately credible and may in fact have been designed as much with near-term rate guidance in mind as they were
with actual expectations for the economy and policy in three years. If the economy really does string together three years of real
GDP growth over 3% leaving the unemployment rate at 5 1/2% at the end of 2016 and inflation at 2%, we see little chance that the
fed funds rate will really be as low as 2% then, whatever the FOMC says now.
At for least for now, though, the market substantially repriced to be fully consistent with the Fed’s rate estimates. The Dec 16
eurodollar futures contract gained 30.5 bp to 2.43%, in line with the FOMC’s median 2% end 2016 fed funds forecast, and the Jan
16 fed funds futures contract rallied 18.5 bp to 1.00%, matching the median 1% end 2015 FOMC forecast. Moreover, the Jun 15
fed funds contract gained 11.5 bp to 0.54%, while the Dec 14 contract gained 6 bp to 0.27%, more consistent with a mid-2015 start
to hikes than the early 2015 (and late 2014 before the employment report) previously priced in. So the market sees a start to hikes
in mid-2015, a 1% end 2015 rate, and a 2% end 2016 rate, matching the FOMC median projections. Beyond the SEP’s forecast
horizon but in line with Chairman Bernanke’s prediction that it could take several years past 2016 to get to an eventual 4% long-run
neutral level, the Dec 17 eurodollar contract gained 29 bp to 3.335%, the Dec 18 contract 19 bp to 4.04%, and the Dec 19 contract
11.5 bp to 4.495%. So with a normal fed funds/eurodollar basis and at least a moderate term premium on longer-dated contracts, it
looks like the market doesn’t have the Fed getting to 4% long-run neutral until 2020.
Underwritten by that substantial repricing of the Fed rate outlook, benchmark Treasury yields rallied 5 to 18 bp to five-week lows
with the belly of the curve leading. The 2-year yield fell 5 bp to 0.33%, 3-year 11 bp to 0.67%, 5-year 17.5 bp to 1.43%, 7-year 18
bp to 2.07%, 10-year 15 bp to 2.70%, and 30-year 9 bp to 3.75%. That left the 10-year 30 bp below the overnight high just over 3%
ahead of the employment report. Gains were entirely in real rates, with TIPS putting in an extremely strong performance led by the
5-year as the lower path for the Fed was reflected. The 5-year TIPS yield fell 24 bp to -0.57%, 10-year 19 bp to 0.49%, and 30-
year 9 bp to 1.45%. In constant maturity yield terms, the 5-year inflation breakeven rose 5 bp to 1.84%, 10-year 4 bp to 2.20%, and
5-year/5-year implied forward 3 bp to 2.56%. Lower coupon mortgages performed extremely well in what was probably a pain trade
generally for the market after a trend of more defensive positioning, moving up in coupon and favoring 15-year MBS over 30-year.
Fannie 4’s outpaced the sharp Treasury market rally by 13 ticks and Fannie 3.5’s by 18 ticks. By Bloomberg’s estimate, the current
coupon MBS yield fell 20 bp to 3.39%, a six-week low. In response, industry leader Wells Fargo cut the 30-year mortgage rate
posted on its web site to 4 5/8% from 4 3/4%, where it had mostly been for some time (with a brief move up to 5% at the preemployment report highs in yields). The volatility market embraced lower for longer with substantial declines led by shorter expiries.
3-month X 10-year normalized swaption volatility plunged 7 bp to 92 bp, near the low end of the range since the June FOMC
meeting after an interim closing high of 122 bp after the June employment report released on July 5.
Prior to the Fed, the housing starts report showed lower than expected overall starts in August, but underlying details pointed to
stronger construction spending. Starts rose a less than expected 0.9% in August to an 891,000 unit annual rate after slightly
downwardly revised results in July (883,000 v. 896,000) and June (835,000 v. 846,000), but the miss in August was all in the more
volatile multi-family category, which fell 11.1% to a 263,000 unit annual rate. Single-family starts rebounded a solid 7.0% to
628,000, reversing the majority of a 10.0% pullback from the February cycle high to July and moving more into line with continued
strength in the homebuilders' survey. The value per unit of single family starts is two to three times higher than for multi-family units,
so the upside in the single-family category pointed to stronger construction spending in August despite the lower than expected
overall starts result. We now see real residential investment gaining 9.1% in Q3 instead of 8.5%, with the homebuilding component
expected to be up 12.3% instead of 10.5%. That didn't change our +2.0% Q3 GDP estimate. About 70% of single-family starts are
intended for the for-sale market (the rest are built on order, by the homeowner, or for rental), so the 628,000 pace in August
equates to about 440,000 additions to the for-sale market. That's shifted above the level of new home sales after the 13.4% plunge
in July to 394,000 and our forecast for a 4.1% rebound to 410,000 in August. Months' supply of unsold new homes rose to a more
long-run normal 5.2 in July with the plunge in sales from a lean 4.3 months in June. So there will likely need to be a renewed turn
higher in home sales in coming months after the initial pullback in response to the recent surge in mortgage rates to support a
continued rebound in single-family starts. Homebuilders have remained very optimistic that we will see that, with the industry
assessment of current single-family home sales and traffic of prospective buyers near eight-year highs in September
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