Senior Consultant
Bridgebay Financial, Inc.
www.bridgebay.com
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.
Federal Reserve
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.
Banking Sector
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
- Capital
- Profitability
- 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.
