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Posted on SEP 21, 2017

Johnson Bank Wealth Weekly Investment Commentary | Thursday, September 21

This is part of an ongoing series of Weekly Commentary articles published by Johnson Financial Group.
This week's issue is written by Brian Andrew, SVP, Chief Investment Officer.

No Promises

Yesterday the Federal Reserve's Open Market Committee (FOMC) concluded their two-day meeting with no change to the Fed Funds interest rate and an anticipated announcement regarding their balance sheet. FOMC Chairman Janet Yellen noted, “We've not made any promises on the path of rates.” With that, the bond market's reaction was predictable.

What Happened

The Fed has raised the Fed Funds rate five times since December, 2015, during which time the rate has gone from 0% to the current range of 1 to 1.25%. Bond investors had anticipated that this meeting would not bring another increase because the level of inflation has waned quite a bit since the beginning of this year. The core personal consumption expenditures deflator (the Fed's favored measure of inflation) is near 1.4%, well below their target of 2%.

Inflation has declined despite the fact that economic activity has picked up during the second and third quarters. Yellen acknowledged this conundrum yesterday, saying, “This year, the shortfall of inflation from 2 percent...is more of a mystery. And I will not say that the committee clearly understands what the causes are of that.” Of course inflation matters because it is one of the key drivers of the level of interest rates.

Treasury yields, and the rest of the bond market, move due to many factors, but one of the most important is the rate of expected inflation. Investors would like to ensure that the interest they earn on bond portfolios exceeds the rate at which prices increase for goods and services. When inflation expectations rise, so too do bond yields. While the academics at the Fed have the luxury of spending months or even years trying to discern the reason for the conundrum (with greater economic growth, why is inflation low?), bond investors must try to set rates based on actual expectations.

Looking at what happened yesterday to bond yields provides some insight into bond investors' views. The 2‐year Treasury is a good proxy for how investors view the future of the Fed Funds rate. The yield rose to the highest level seen since 2008 and now stands near 1.45%. At the same time, the yield on a 10‐year Treasury rose only slightly to 2.3% and remains near a level we've traded around for several years. Why the difference?

Investors who are buying the short‐end of the yield curve understand that the Fed will continue to hike rates, albeit more slowly than they've said, for some time. This gets reflected in yields. While the Fed did not hike rates yesterday, they did leave the door open for a December rate hike of .25%, explaining that while they don't understand why inflation is low, they believe “low inflation is transitory” and leaves room for a hike later this year. The futures market, where investors set the probability of a future hike in December, has risen from a 30% to a 64% probability in the last month. Of course, there are no promises.

The Fed also announced a much‐anticipated and well‐described change in how it manages its balance sheet. This tapering will result in a reduction in the size of the balance sheet and removal of some liquidity from the banking system. You'll recall the term quantitative easing, in which the Fed bought Treasury and mortgage‐backed securities. The cash proceeds of these purchases went into bank coffers with the hope of those banks using the funds to increase lending activity. After growing its balance sheet from less than $1 trillion to almost $5 trillion, the Fed has decided it is finally time to reverse course, albeit slowly. It will begin by allowing $10 billion per month (raised by $10 billion each quarter) to roll off. This will slowly reduce Fed holdings and the amount of liquidity banks hold. Given the increased capital requirements from Dodd Frank and the improvement in bank earnings, this should not be concerning.

What Now

We don't see the Fed's conundrum changing much in the near future. Economic growth will likely slow in the fourth quarter of this year, resulting from the fact that interest rates moved up almost 1% in the fourth quarter of 2016 and early first quarter of this year. However, since then, the intermediate part of the yield curve has declined by almost half a percent, suggesting that growth in early 2018 could pick up. We also have the potential for tax reform aiding consumption and corporate business spending, which would also be a growth catalyst. Adding to this uncertainty is the fact that almost half of the Fed's Board of Governors may change over the next 12 months, including possibly its leadership.

For now it looks like the Fed will remain on course to raise rates slowly (although they make no promises) and reduce the size of their balance sheet. Despite this morning's headlines making this look like a big event, it is really more business as usual.

Brian Andrew
As Chief Investment Officer, Brian Andrew leads Johnson Financial Group's investment strategy
to provide consistent, actionable investment solutions for our clients.

This information is for educational and illustrative purposes only and should not be used or construed as financial advice, an offer to sell, a solicitation, an offer to buy or a recommendation for any security. Opinions expressed herein are as of the date of this report and do not necessarily represent the views of Johnson Financial Group and/or its affiliates. Johnson Financial Group and/or its affiliates may issue reports or have opinions that are inconsistent with this report. Johnson Financial Group and/or its affiliates do not warrant the accuracy or completeness of information contained herein. Such information is subject to change without notice and is not intended to influence your investment decisions. Johnson Financial Group and/or its affiliates do not provide legal or tax advice to clients. You should review your particular circumstances with your independent legal and tax advisors. Whether any planned tax result is realized by you depends on the specific facts of your own situation at the time your taxes are prepared. Past performance is no guarantee of future results. All performance data, while deemed obtained from reliable sources, are not guaranteed for accuracy. Not for use as a primary basis of investment decisions. Not to be construed to meet the needs of any particular investor. Asset allocation and diversification do not assure or guarantee better performance and cannot eliminate the risk of investment losses. Certain investments, like real estate, equity investments and fixed income securities, carry a certain degree of risk and may not be suitable for all investors. An investor could lose all or a substantial amount of his or her investment. Johnson Financial Group is the parent company of Johnson Bank, Cleary Gull Advisors Inc. and Johnson Insurance Services LLC. NOT FDIC INSURED * NO BANK GUARANTEE * MAY LOSE VALUE

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