Goldman Expects the Fed to Do More as Financial Conditions Prove Resilient

  • Global gains revive questions about Fed policy effectiveness
  • Broad macro risks key driver for Treasuries, Bank of America

Rivlin Sees Fed Staying on Track Despite Uncertainty

The Federal Reserve hasn’t lost its mojo.

Policy makers just need to work it a little harder when it comes to influencing the U.S. business cycle. That’s the conclusion of Goldman Sachs Group Inc. analysts with financial conditions easing in the past six months even after two interest-rate increases and the looming unwind of the central bank’s balance sheet.

“Fed policy -- especially Fed policy communicated around FOMC meetings -- only accounts for a relatively small part of the ups and downs of financial conditions,” wrote Goldman economists lead by Jan Hatzius in a note late Wednesday. “Other developments such as the sharp pickup in global growth have been helpful for U.S. financial conditions by boosting risk assets while keeping the U.S. dollar from appreciating sharply in response to higher short-term interest rates.”

That all just means the Fed has to hike more this year, keeping pace with three to four hikes needed overall each year through the end of 2019, Hatzius adds -- which is in line with Goldman’s present forecast.

Federal Reserve Bank of Boston President Eric Rosengren urged his policy-making colleagues Tuesday to raise rates three more times this year and consider starting to shrink the $4.5 trillion balance sheet after their next hike to avoid creating an “over-hot economy.” He cited his and other economist views that growth will prove above potential -- pushing the unemployment rate, now at 4.4 percent, even further below what he sees as a level of full employment of 4.7 percent. Rosengren also noted global risks had waned, reflected in higher U.S. and world stock prices.

So far America’s debt traders haven’t fully gotten in line with the Fed’s forecast of two more hikes in 2017, yet they are getting closer, pricing in now about 1.6 more increases. More tightening could come through if the Fed announce plans to reduce the amount of its maturing debt proceeds it rolls into new debt, allowing their balance sheet to shrink.

Movements in Treasury yields in a brief intra-day window around the past 124 Federal Open Market Committee meetings show on average a policy-driven 1 percentage point rise in the two-year Treasury yield causes 10-year yields to rise -- yet by a smaller degree -- and stock prices to slide and the trade-weighted value of the dollar to rise, which results in a 0.68 percentage point tightening of financial conditions, the Goldman team’s analysis shows. The central banks ability to steer financial conditions has actually grown this year as well.

Given the Fed’s tools are still as strong as ever, their take-away is merely that more rate tightening is in order.

“Fed officials should be able to achieve their goals for financial conditions by moving the funds rate if they try hard enough,” Hatzius and his team wrote. “We view rate hikes of 50 to 75 basis points per year, relative to the current market pricing, as a reasonable range.”

Swings in risk assets here and abroad are wielding more power of Treasury yields along with their force over Fed policy implementation, according to rates strategists at Bank of America Corp. An aggregate metric of option skew, a gauge of demand for those that hedge rising or falling prices, including those on ishares 20-year bond ETF, gold, the Japanese yen and the S&P 500 Index shows rate investors are more attuned to swings in other asset classes. Spikes in the BofA skew, as charted below, precede risk-off related slides in Treasury yields, wrote Carol Zhang, one of the bank’s rates strategists in a note.

“Rates investors are now focused more on messages sent by other asset classes as opposed to their own,” Zhang wrote Tuesday. “We believe one of the biggest concerns for bond bears is the potential of a prolonged correction to risk assets.”

— With assistance by Brian Chappatta, Matthew Boesler, and Christopher Condon

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