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Posted by on Sep 22, 2017 in Crossing Wall Street, Featured, Market Insight

Crossing Wall Street Review – September 22, 2017

Crossing Wall Street Review – September 22, 2017

By Eddy Elfenbein, editor of Crossing Wall Street and portfolio manager of the AdvisorShares Focused Equity ETF (Ticker: CWS)
 

The Federal Reserve Holds Firm

 
Lately, I had been telling you that the Federal Reserve won’t be raising interest rates any time soon. Silly me. I was assuming the Fed was going off the evidence. Big mistake.

We had five very soft inflation reports in a row. Only the last one was anything close to the Fed’s target of 2%. Let’s look at some the recent data. Last Friday, the Fed said that industrial production fell by 0.9% last month, and Hurricane Harvey was responsible for 0.75% of that. We also learned that retail sales fell 0.4% in August. Take out gasoline, and retail sales still fell 0.2%. That’s not good.

The Atlanta Fed’s GDP model now sees Q3 coming in at 2.2%. The New York Fed’s model is down to 1.3%. Sure, Harvey bears some of the blame, but not all. The economy is growing, but at a tepid pace.

But the Fed is having none of this. On Wednesday, the central bank released its policy statement, along with its revised economic forecasts. I should warn you that the Fed’s track record isn’t merely bad—it’s bad for economists.

Let’s dig into the policy statement. Not surprisingly, the Fed decided against raising interest rates at this meeting. That means the target for Fed funds remains between 1% and 1.25%. In the statement, they acknowledged the damaged caused by the hurricanes, but added that “the storms are unlikely to materially alter the course of the national economy over the medium term.” This is probably true. Plus, a lot or rebuilding news to be done.

The Fed also said the economy is growing moderately and the jobs market continues to get better. They also said that core inflation is low, and will probably remain so. I agree.

Now let’s turn to the Fed’s economic projections. This is often referred to as the “blue dots,” due to the dot plot in the report. The Fed now sees core inflation rising to 1.9% next year, and 2% in 2019. Mind you, the Fed has consistently overestimated future inflation. Not only that, but if anything, core inflation was been trending downward. It’ll probably something like 1.5% this year. Don’t get me wrong: I’m all for the Fed battling inflation. But I’m not wild about fighting inflation that doesn’t appear to exist.

Of the 16 members on the FOMC (not all of whom vote at policy meetings), 12 see another rate increase in December. Prior to the meeting, the futures market thought there was a 37% chance of a December hike. Now that’s up to 78%.

For 2018, the median forecast calls for three more rate hikes. That would bring the Fed funds target range to 2% to 2.25%. On a side note, if the Fed’s inflation forecast is correct, that would mean the real (or inflation-adjusted) range would finally be positive. It’s been negative for nearly a decade. In other words, you could borrow money from the Fed for free, after adjusting for inflation.

The median Fed forecast calls for one more hike in 2019, plus another one in 2020. The Fed also projects inflation and interest rates for the “long run.” (“But this long run is a misleading guide to current affairs. In the long run we are all dead.” – JM Keynes.)

Here’s an interesting nugget. The Fed members see long-run interest rates at 2.75%. Combined with the long-run inflation forecast of 2%, this implies the Fed believes the “equilibrium rate” is 0.75%. That’s the interest rate at which (theoretically) everything should come into balance (again, theoretically). I’d guess that if you polled economists on the equilibrium rate prior to the financial crisis, they probably would have pegged it around 2%. So as long as the Fed is below 0.75% in real terms, they view themselves as pumping up the economy.

Remember that for much of 2017, long-term interest rates have been falling. Lots of other people were betting that the Fed would take a breather. But in the last two weeks, a lot has changed. The yield on the 10-year bounced from 1.88% on September 7, to 2.11% on Thursday.

That’s not all. The yield on the two-year Treasury is now up to 1.45%. That’s the highest in nearly nine years. The two-year is a good maturity to watch, because it’s usually very sensitive to interest-rate expectations. For some context, six years ago, the two-year was yielding as low as 0.16%.

What does all this mean? A December rate hike from the Fed won’t be a disaster. The problem is that it gives the Fed less room to operate if and when things get bad. There’s also no reason to worry about the stock market. The market can rally along with higher rates. That’s what happened from 2004 to 2006.
 

The information, statements, views, and opinions included in this publication are based on sources (both internal and external sources) considered to be reliable, but no representation or warranty, express or implied, is made as to their accuracy, completeness or correctness. Such information, statements, views and opinions are expressed as of the date of publication, are subject to change without further notice and do not constitute a solicitation for the purchase or sale of any investment referenced in the publication.

The AlphaBaskets blog provides frequent market insight and commentary by AdvisorShares Investments, LLC, created by AdvisorShares and other leading active managers.  AdvisorShares Investments is an SEC-registered investment adviser and the investment adviser to the AdvisorShares actively managed ETFs. The views expressed on AlphaBaskets should not be taken as investment advice or a recommendation for any of the actively managed ETFs advised by AdvisorShares.

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