Plant a Tree Today, Sit in the Shade Tomorrow

The Federal Reserve’s desire to be predictable should lead to an incremental path for the coming tightening cycle and that suggests increasing exposure to floating-rate instruments.

March 25, 2014    |    By Scott Minerd

Global CIO Commentary by Scott Minerd

Federal Reserve Chairwoman Janet Yellen has made it clear that tapering is on a pre-set roadmap and that interest rates will begin to rise no sooner than six months after the Fed’s asset purchases end. We see the specific timing becoming increasingly dependent on U.S. inflation, and financial markets agree, as shown in our chart below on inflation sensitivity.

Call it luck or a get-out-of-jail-free card, but the Fed is executing taper just as there is a flight to quality into U.S. Treasuries as a result of geopolitical uncertainty in Ukraine. Helping the Fed further is the secular shift in China toward liberalizing the renminbi to combat the unprecedented depreciation of the Japanese yen. Beijing’s need to depreciate the RMB will likely be accomplished by buying U.S. Treasuries, compensating for the Fed’s withdrawal of liquidity.

Looking past the debate about what day of the week or what month of the year the Fed will hike interest rates, we can gather insight about what that world will look like from the last tightening cycle. When the Fed, under the stewardship of Dr. Alan Greenspan, last began to raise interest rates in 2004, they borrowed a leaf from the Bundesbank’s book of monetary policy tricks and did so in gradual increments of 25 basis points at every Federal Open Market Committee meeting. With the Fed now very concerned about behaving in a predictable manner, once Dr. Yellen decides the time is right to start tightening, we can again expect gradual incremental hikes of 25 basis points at every FOMC meeting. Such a path would see interest rates starting to rise at the earliest in mid-2015, adding two percentage points to the fed funds target rate every year.

We know from every business cycle in the post-war period that as the Fed continues raising rates the Treasury yield curve becomes flatter, and in time, the 10-year U.S. Treasury note actually trades below the fed funds rate. Understanding how yield curve shifts occur during periods of tightening monetary policy will be crucial as investors position portfolios for the realities of a more restrained monetary environment. All of this suggests increasing exposure to floating-rate instruments while retaining flexibility to take advantage of intermittent flights to quality.

U.S. Markets Increasingly Sensitive to Inflation

With tapering of the Federal Reserve’s asset purchases unlikely to deviate from its pre-set course of a $10 billion reduction per FOMC meeting, speculation is rising about the timing of the first increase of the federal funds target rate. The catalyst for the Fed to hike rates will likely be rising inflation, which is increasing investor sensitivity to inflation data as the inevitable rate hike nears. Since the beginning of QE3, inflation surprises (core CPI data above or below consensus expectations) have become increasingly correlated with volatility in the 10-year U.S. Treasury yield, suggesting inflation is becoming a bigger focus for investors.



Source: Bloomberg, Guggenheim Investments. Data as of 3/18/2014. *Note: We define inflation surprises as the difference between the core CPI month-over-month percentage change and Bloomberg’s median forecast. Core CPI is used because it is the first inflation data point released (i.e. before Personal Consumption Expenditures).

Economic Data Releases

U.S. Home Sales and Prices Continue Winter Weakness

  • Existing home sales were mostly flat in February, in line with expectations. Sales were 4.6 million at an annualized pace, led by a strong demand for higher priced homes.
  • New home sales disappointed in February, with the annualized rate of sales falling to 440,000 from 455,000 with adverse winter weather likely weighing on the data.
  • The S&P/Case-Shiller 20-city home price index showed a decelerating pace of growth in January, rising 13.24 percent from a year earlier, down from November’s high of 13.71 percent.
  • The FHFA house price index rose slightly less-than-expected in January, up 0.5 percent from a month ago. Eight of nine regions saw price gains.
  • The Conference Board’s Leading Economic Index rose 0.5 percent in February, the most in three months. Five of 10 categories were up, including building permits and the interest rate spread.
  • The Conference Board’s Consumer Confidence Index rose in the March survey to 82.3, the highest level in over six years.
  • Initial jobless claims rose slightly in the week ended March 14th, ticking up by 5,000 to 320,000.
  • The Philadelphia Fed Business Outlook Survey rebounded to 9.0 in March as new orders rose but employment fell.
  • Durable goods orders jumped 2.2 percent in February, mostly due to a surge in auto orders. However, orders for non-defense capital goods (excluding aircraft) unexpectedly dropped 1.3 percent, the second decline in three months.

Euro Zone Confidence Improves, But Germany Falters

  • Euro zone consumer confidence surged in March to the best level since 2007. The gain was the largest one-month increase in five years.
  • The euro zone manufacturing PMI ticked down in March from 53.2 to 53.0. The services PMI also fell slightly.
  • France’s manufacturing PMI jumped to 51.9 in March, the highest since June 2011. Germany’s manufacturing PMI missed estimates and fell for a second consecutive month.
  • Germany’s IFO business climate index fell for the first time in four months in March as expectations deteriorated.
  • Germany’s GfK consumer confidence survey was flat for April, remaining at the highest level since 2007.
  • Italian consumer confidence rose to 101.7 in March, a 33-month high.
  • The CPI in the United Kingdom decreased to 1.7 percent year-over-year in February, the lowest since October 2009.
  • China’s HSBC manufacturing PMI unexpectedly fell for a fifth straight month in March, down to 48.1, causing increased speculation of possible government stimulus measures.


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