Bank of America Merrill Lynch on Dudley COmments

February 28th, 2015 7:46 am | by John Jansen |

Yesterday I posted this and this on comments by New York Fed President William Dudley on level of long term rates as the FOMC hikes short term rates. The gist of his comments is that there will be no  Greenspan like “conundrum” which keeps long rates low as the FOMC drives short rates higher. As a corollary the FOMC will not wink and assure dealers that every increase will be 25 basis points. There will be some uncertainty regarding the funding trajectory and actually some fear that the FOMC could lob a 50 basis point hike at the economy if necessary. Dudley views the lower long term rates as stimulative and feels the FOMC must raise those rates to be effective. Therefore, if an aggressive short term rate stance is necessary he will support that.

Via Bank America Merrill Lynch Research:

Hiking long term interest rates
Summary
  • Dudley’s remarks highlight why we should expect the coming rate hiking cycle to be much less favorable that the previous one.
  • Clearly if Dudley’s views are shared the Fed is going to want to see higher long term interest rates once they start hiking.
  • This is one reason we are only tactically (next 0-2 months) overweight IG credit, and not longer term.
  • Hiking long term interest rates. New York Fed President William C. Dudley’s remarks at the February 27th 2015 U.S. Monetary Policy Forum highlight once again why we should expect the coming rate hiking cycle to be much less favorable to asset prices than the previous (2004) cycle. This is because the 2004 environment of Fed rate hikes, rallying stocks, tightening credit spreads and long term interest rates that did not increase was a policy mistake (see: The Fed’s dual goals: wider spreads, higher vol). Remember that in each cycle there comes a point when the Fed must hike interest rates in order to tighten financial conditions to avoid a situation where the economy overheats and bubbles are created. Clearly, with the benefits of hindsight, in 2004 when the Fed was hiking the Funds Rate, financial conditions actually loosened significantly. This was one of the reasons for the housing bubble and the trouble we have been in during the post crisis years. Thus, while financial market charts from 2004 are amazing and pretty, the longer run costs from the policy mistake of not tightening monetary policy aggressively enough were severe.
  • Clearly, if Dudley’s views are shared by other members of the FOMC – and by Chair Janet Yellen in particular, with whom his views are often closely aligned – the Fed is going to want to see higher long term interest rates once they start hiking, as well as stocks and credit not rallying. This view runs counter to the consensus among credit investors that the Fed by 2004 had learned to hike rates in a way that was amazing for financial markets, and thus we need not worry about the coming rate cycle. Again, Dudley specifically does not want a repeat of 2004.
  • This is one reason we are only tactically overweight IG credit (see: Tactically overweight). We are bullish the next 0-2 months, as strong economic data and the resulting rebound to 2% 10-year interest rates are positive for spreads. Additionally, US credit benefits from attractive relative value to EUR credit, as well as the general global re-allocation into US fixed income. If we were not concerned about the Fed, this would be a longer term view. Furthermore, should the Fed communicate to the market a goal of higher long term interest rates as well, the risk would be that the global re-allocation flows that currently benefit US fixed income pause. Thus, we are much more bearish on credit into the summer and fall…. (Page 7)
  • USD-EUR spread compression. USD high grade spreads have significantly outperformed their EUR counterparts in February and year to date. Being tactically overweight USD credit, and with tight valuations in Europe, we look for this outperformance to continue. In February 10-year USD bond spreads tightened 8bps relative to EUR spreads for European issuers and, similarly, by 9bps for US issuers. Year-to-date USD spreads of European issuers outperformed the corresponding 10-year EUR-denominated bond spreads by an even larger margin of 21bps. We estimate that 10-year spreads in EUR are 26bps tighter for European issuers and 8bps tighter for US issuers. (Page 17)
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