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Goodbye Yellen Brick Road

21 November 2017 by Mark Holman

Yesterday’s announcement that Fed Chair Janet Yellen would be stepping down from the Board of Governors once the new Chair, Jerome Powell, is sworn in came as no surprise to us or the markets. She has had the perfect period to preside over with no real surprises, no recession, and having learned the importance of clear communication and forward guidance from previous Fed Chair Ben Bernanke, who will most likely be best known for his taper tantrum. What will Janet be best known for? Well she did successfully bring asset purchases to an end and she did implement the first rate hike, but she will go down in history without a moniker such as “irrational exuberance” or a “taper tantrum”. Good for her; a job exceedingly well done.

The next Chair is unlikely to have such a smooth ride and will probably have to negotiate a recession when this cycle finally comes to an end. No easy task when the Fed is still already highly accommodating and there is little ammunition to stimulate with as things stand. This is the principal reason why we think the Fed will push ahead with a series of rate hikes starting in December this year and adding probably three more in 2018. They have already achieved one of their two goals – full employment – but the 2% inflation target remains hard to reach. However, despite this, the less risky path for the Fed is to continue to hike gradually so that they have more firepower for when this cycle does finally end.

One worry to this thesis might be that the Fed will need 4 new members next year including a Vice Chair, but with the continuity vote already decided through the appointment of Mr. Powell we see a level of consistency in policy as our base case with the new appointments.

While talking about the end of the cycle we should also make it clear that we do not see this happening in 2018; perhaps by this time next year we will have more clues as to when it might be but for now there is every chance that the current period of sustained economic growth will become the longest period since the second world war.

So with the 2018 FOMC members following Yellen’s well-trodden path, what does that mean for Treasury yields?

We see a continuation of the gradual bear flattening of the curve, the rationale being that the four hikes from here are, in theory, only 17% priced in. Most pain will be at the front end of the yield curve, but a pre-emptive Fed that is hiking without too much of an inflation worry should preserve yields at the longer end, hence the bear flattening. We see 10 year yields modestly higher in the 2.75% to 3% area and the 30 years still flatter in the 3% to 3.25% area. Still, both are high enough to generate a negative total return from here, so their use should be more tactical than strategic while the move takes place. A spike higher from here might provide a better entry point for strategic holdings.

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