Bridgebay Financial, Inc.
Global Central Banks
There are now 25 central banks that have eased, added substantial stimulus to their economies and lowered their target interest rates comparable to the Fed Funds rates. Central bank support means international bond yields are likely to remain low, while they appear poised to rise in the U.S. All of these accommodative efforts are designed to combat deflation but have also driven up the value of USD. Diverging central bank monetary policies and political risk in Europe will lead to increased volatility in equities, fixed income and currencies.
The FOMC March 17-18, 2015 meeting minutes indicated differences as to the timing of rate hikes and the prevailing economic conditions. Although some Fed members favored a June rate hike, September-December is now expected with gradual increases to follow. The Fed is focused on trade, economic growth, the strength of the USD and the effects of lower energy prices. The Fed is monitoring the strong USD and its potential drag on exports and overall growth.
The Fed is positive about the underlying consumer spending over the medium-term, improvement in jobs, the wealth effect from improved house and stock valuations, stronger consumer balance sheets, lower energy prices and higher consumer confidence. The Fed is tracking payroll gains, labor market slack with less emphasis on wage growth.
Interest Rate Hikes
The FOMC lowered their interest rate forecast by 50 bps in 2015. FOMC consensus now signals a September hike, followed by 100-125 bps of rate hikes in 2016. The Fed lowered its forecasts and now expects growth to be 2.3-2.7% and core inflation to be 1.3-1.4% in 2015, below its 2% target.
The USD has appreciated by 7% since December and 20% against global currencies over the last 6 months. The Fed’s model indicates that a 10% increase in the USD reduces US growth by 0.7%, reduces core inflation by 0.4% and applies pressure to keep Fed Funds rate lower for longer.
Moody’s announced their updated bank rating methodology that incorporates several solvency and liquidity factors. Their intent is to predict bank failures and determine how each creditor class may be treated when a bank fails. The new methodology will focus on an enhanced Financial Profile which encompasses five solvency and liquidity-related financial ratios that are predictive of bank failures:
- Asset Risk
- Funding structure
- Liquid resources
This new approach reflects insights gained from the global financial crisis and the fundamental shift in the banking industry and its regulation.
European banks located in the EU, Norway and Switzerland, whose government support has been partially removed will be impacted by 3 ratings notches. The effect of the new methodology takes a loss given failure approach and gives credit for available layers of subordinated liability when assigning ratings to senior debt. This approach changes the focus from sovereign ratings to name-specific and quality of bank capitalization.
Moody’s already implemented their ratings changes on US Banks when it removed its assumptions for government support. Some holding companies of UK banks were negatively impacted by the (BRRD) Bank Recovery and Resolution Directive. Canadian, Australian and Japanese banks were not affected by Moody’s methodology changes.
Fixed Income Markets
The search for yield and pension fund de-risking should flatten yield curves throughout 2015. The market expects the Treasury curve to flatten and the dollar to continue to strengthen, but credit markets could see some temporary spread widening.
There may be a modest rise in Treasury yields along with some flattening of the yield curve as short-term rates rise more than long-term rates. The USD may continue to strengthen as monetary policy diverges between the U.S., Europe and Japan and credit spreads may initially widen.
The recent weakness in the U.S. data is partly weather-related and may have been influenced by the port shutdowns on the West Coast given the impact on the regional manufacturing surveys. At the present time, the Fed expects to increase interest rates by an average of one percentage point per year through 2017.
Such a gradual pace of rate hikes is not likely to derail the economic expansion nor should it have a lasting impact on risk assets. As the Fed prepares to raise interest rates, it is expected to keep its target interest rate within a narrow band. The top of the band will be the interest on excess reserves (IOER), which is the interest the Fed pays banks for the money they have on deposit at the central bank. This rate is currently set at 25 basis points (bps) and seems likely to rise to 50bps with the Fed’s first rate increase. The lower end of the band will be the interest the Fed pays money market funds and other nonbank institutions for cash not on deposit at banks (overnight reverse-repo rate).
The Fed’s projections show the long-term equilibrium Fed Funds rate may be 3.5% which is still historically low.