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The past quarter has been a roller coaster ride for longer-term interest rates while short-term rates steadily moved higher.  Throughout the majority of the quarter we saw longer-term rates rally with the 10-year reaching a low of about 2.04% on September 7, as subsiding inflation and concerns around escalating tensions between the U.S. and North Korea weighed on longer-term yields.  This move was quickly followed by a fairly sharp reversal to higher yields, as statements from U.S. officials regarding North Korea’s hydrogen bomb tests eased investors’ concerns of imminent escalation.  Yields continued to rise as the announcement and release of a tax reform outline came in the second half of September.  Additionally, the Fed officially announced that the process of unwinding its balance sheet will begin in October.  When all was said and done for the quarter, yields were generally higher across the curve but the largest increases were seen on the short end of the curve.  Specifically, the one- to three-year sectors were up about 7bps on average, while the rest of the curve was up around 2bps on average. 


While disinflation was the story for most of the quarter, the bond market was a bit jolted in the last few weeks of September as the prospects for successful tax reform improved relative to investors’ expectations following the announcement and release of the President’s tax reform outline.  This caused a repricing in market-based measures of inflation expectations (or breakevens), which are measured by taking the difference between nominal Treasury yields and the yield on an equal maturity Treasury Inflation Protected Security.  Inflation expectations measured by this difference have increased +12bps at the 5-year and 10-year maturity points since the end of June through the end of September.  This may seem contradictory with some of the weakness seen in the Consumer Price Index and Personal Consumption Expenditure readings, but we must remember that markets are forward looking while economic releases look backwards. 


Since we’re on the topic of tax reform and the impact it has had on markets, let’s take a closer look at some of the major proposed changes:

  Corporate taxes:        

    o Corporate tax rate reduced to 20% from 35%  

    o Pass-through rate reduced to 25% from 39.6%   

    o Corporate alternative minimum tax eliminated  

    o Corporate taxes will move to a territorial system  

    o Immediate expensing of new capital investments   

    o Partially limited interest deductibility for C corps   

    o Global minimum tax on foreign profits of multinationals – rate not yet specified


 Individual taxes:   

    o Consolidate current seven tax brackets into three: 12%, 25% and 35%.        

         Potential to add fourth for wealthiest taxpayers        

         No income levels set so far for brackets    

    o Standard deduction increased to $12,000 for individuals and $24,000 for married couples   

    o Eliminates personal exemptions   

    o Eliminates most itemized deductions including state and local tax deductions 

         Retains mortgage interest and charitable giving as deductions   

    o Eliminates individual AMT   

    o Repeals estate and gift taxes 


There is no doubt the recent progress made on establishing a blueprint for tax reform has increased the probability of successfully passing a tax reform package.  However, the current budget resolution has carved out $1.5 trillion for tax reform, while the current outline is roughly $2.5 trillion.  The Senate budget resolution also includes a $1.2 trillion “dynamic feedback effect” over the next 10 years, or the idea that tax reform will lift growth, and this higher growth rate will increase tax revenues to offset the lower tax rates.  This assumption is very optimistic, and it’s likely that the Congressional Budget Office will have a much more conservative assumption in regards to feedback effects.  So, there is still risk that this package does not get fully implemented or potentially not done at all. 


Fedspeak

It has been a quiet front for the Fed this past quarter as policy makers left the fed funds rate unchanged since the last hike in mid-June, but there have been some developments that are worth noting from the September meeting, specifically.  In this most recent FOMC meeting, policy makers finally announced the beginning of the end for unconventional monetary policies. The Fed will cease reinvestment of maturing principal payments from Treasuries and mortgage-backed securities and will let its holdings roll off in a “gradual and controlled manner”. 

While we believe that quantitative easing is a policy that will remain in the Fed’s toolkit for potential use in the future, this is the first step to normalizing the Fed’s balance sheet towards a level more consistent with the size of its balance sheet prior to 2008.  We do not believe that unwinding quantitative easing will have a material impact on the market as long as the Fed sticks to the plan of allowing its balance sheet to shrink naturally as holdings mature.  We do believe that if the Fed tries to sell securities in the open market to shrink its balance sheet at an accelerated pace, this would likely disrupt bond markets by adding supply that the market is not prepared for.  Our view, though, is that the Fed is unlikely to sell securities unless it feels it is getting behind the curve with inflation. 


Also of interest from the September meeting are the slight changes in FOMC participants’ forecasts in the dot plot.  We can see in the chart below that projections for the fed funds rate are almost unchanged for 2017 and 2018 from June to September.  However, projections for 2019 and the longer-run scenario (2020 was just added in the September meeting) suggest that the median projections have declined slightly. 



Since the beginning of the tightening cycle in December 2015, projections for the future fed funds rate have consistently declined with each new updated dot plot. So, one could argue that this is nothing new and might be a reaction to the lower inflation readings we have seen the past three months. However, shortly after the September meeting, Janet Yellen gave a speech with a more hawkish tone than the September dots might suggest.  Yellen argued that this year’s low inflation is probably temporary and that the Fed should “be wary of moving too gradually” in terms of tightening monetary policy.  With the risk of labor markets overheating, Yellen stated that “it would be imprudent to keep monetary policy on hold until inflation is back to 2%.” 


There is definitely merit to Yellen’s argument, especially after September’s employment numbers showed a decent drop in both the unemployment and underemployment numbers, while wages have accelerated for the first time this year.  But if September’s employment numbers were a one-off, and if the Phillips curve is flatter in this cycle than historical norms, the inverse relationship between lower unemployment and higher inflation would be weaker than historically suggested.  Even the Fed is questioning the strength of the Phillips Curve in predicting inflation; a paper1 released in August at the Philadelphia Fed suggested that “policymakers should at best be very cautious in their reliance on the Phillips curve when gauging inflationary pressures.” 


We understand the importance of normalizing monetary policy so that the Fed has room to move during the next downturn, as well as the risks of deficit-financed stimulus with unemployment at cycle lows.  But we also hope that the Fed remains data dependent and does not get too aggressive in tightening monetary policy, especially while it moves into uncharted territory with reducing the size of its balance sheet (another form of removing accommodative monetary policy). Raising rates too aggressively while reducing the size of its balance sheet, or winding down the balance sheet at an accelerated pace, could tighten monetary and financial conditions faster than the Fed may desire.



1 WORKING PAPER NO. 17-26 DO PHILLIPS CURVES CONDITIONALLY HELP TO FORECAST INFLATION?, Michael Dotsey, Shigeru Fujita, Tom Stark

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