Since the March Federal Open Markets Committee (FOMC) meeting, it is increasingly clear that the US Federal Reserve (Fed) believes that the US economy is approaching a state where zero rates are no longer warranted. Due to the long lead times of monetary policy and the decline in resource under-utilisation, which should give confidence that inflation will eventually return to the 2% target, the Fed seems to feel that it's time to start lifting interest rates.
However, the timing and pace of rate rises is very much data-dependent. As Fed Chairperson Janet Yellen stated in a recent speech, "the actual path of policy will evolve as economic conditions evolve, and policy tightening could speed up, slow down, pause, or even reverse course depending on actual and expected developments in real activity and inflation." Although the Fed wants to start lifting rates above zero, it believes the economy still requires a certain degree of accommodative monetary policy. Additionally, zero rates add an asymmetric risk - if the economy falters, the Fed's ability to act is restricted, particularly since another round of quantitative easing (QE) might be limited by the Fed's already large balance sheet.
Lessons from history – Fed attempting to avoid a 1937-style recession
There has been much speculation that any early withdrawal of stimulus could lead to a similar situation developing as in the late 1930s. The US economy was in the process of recovering from the Great Depression, but fell back into recession in 1937 and was only eventually rescued by wartime spending in 1941. The causes of the 1937 recession are the subject of some dispute but are most often attributed to a tightening of fiscal and monetary policy. At that time, the US Fed tightened commercial banks' reserve requirements, cut federal spending, increased taxes and tightened fiscal policy by reducing the deficit.
Debate continues as to which of these factors caused the recession or whether it was a combination of them, but the government and its agencies were concerned that gold inflows and excess reserves would lead to inflation. Authorities started to focus, perhaps prematurely, on inflation, when the economy was not yet strong enough to withstand such tightening measures. Some economists have used 1937 as an example of what could happen if the Fed tightens policy too aggressively, resulting in a higher US dollar, falling inflation and weakening growth.
However, prudent policy is likely to prevail given the Fed's concern that at zero rates they have an asymmetric risk profile to negative shocks and their desire to avoid another 'taper tantrum' in the bond market. Yellen has said that any financial stability problems associated with having low interest rates for too long would be dealt with by macro regulatory and supervisory controls. This is a clear change from the Greenspan years, which saw a weakening of regulatory controls in the name of market efficiency.
Federal Reserve faces some headwinds as it normalises monetary policy
With the US, Europe and Japan engaging in diverging monetary policies, we have seen an uplift in foreign exchange (FX) and interest rate volatility. This is unsurprising given that much remains uncertain. If it succeeds, the Fed will be the first central bank to successfully normalise rates. Countries like Sweden and Australia have tried and been unsuccessful. Although these countries are smaller and more open to the world economy, the US is making the attempt when global growth is weaker and more countries are using competitive devaluation to kick-start their economies.
Another area of uncertainty is the US economy itself - is it as strong as the labourforce data suggests? GDP numbers for 2014 were generally mixed, with very strong quarterly numbers for the second and third quarters, a very poor weather-affected first quarter and the fourth quarter seeing some moderation. As we enter 2015, the first quarter is again showing weather-affected weakness and this underperformance means that labour productivity is barely growing. With real wages going up, largely due to falling prices, it remains to be seen whether the labour market can maintain its present level of growth.
The Fed's monetary policy tightening will undoubtedly have some initial effect on US Treasuries, but for their long-term reaction we should consider Europe. The rise in the US dollar has been driven mainly by the depreciation of the Yen and Euro, which has led to a rise in US bond yields vs. Japanese and European bonds. As a result of the European crisis, Europe is running a large trade surplus and the external assets of the banking system are now nearly as large as in 2007/2008 prior to European banks' deleveraging. With negative rates in Europe, it is likely that we will see further capital flow out of Europe and into the US finding its way to the bond market, which would keep yields lower than would otherwise be the case. If Europe did start to recover, we should see a weaker US dollar and those capital flows should reduce, relieving pressure on US bonds and leading to a rise in yields. Therefore, the direction of US bond yields depends as much on Europe as on the Fed.
Conclusion: Likelihood of a 1937-style recession is remote
Interest rate and FX volatility has increased as the market anticipates the time when the Fed will start to reduce monetary accommodation and raise interest rates. In our view, the chances of another 1937-style recession are remote. The Fed has signalled that it will be following a steady and controlled path with more transparent market communication in an attempt to avoid another 'taper tantrum'. Unlike in 1937, inflation isn't currently of major concern to the Fed so they are not likely to tighten rates too fast in an effort to control it.
Despite the recent fall in energy prices and the strong US dollar, the Fed views their impact on inflation as transitory, while the effect of QE globally should eventually help lift world growth and US exports. In terms of the outlook for US Treasuries, it is not just the actions of the Fed that matter - the response of European and Japanese economies to their QE programmes will be vitally important.