The hope for economic growth much beyond 2.0% looks to be deferred, as legislation appears to be bogging down and the Fed is reducing monetary support, clearly taking the path to interest rate normalization.
Hope is fading for robust economic growth fueled by tax reform, infrastructure spending and regulatory reform. Writing and signing major legislation takes far more time and effort than executive orders. Before arriving at the potentially stimulative tax reform and infrastructure spending we need to get through the repeal and replacement of the Affordable Care Act, the budget process and immigration reform. All these issues are politically contentious, and compromise will likely prove time consuming. Once we reach tax reform, the Border Adjustment provision looks to be a major stumbling block for many important constituents. We do take some comfort in the possibility of regulatory relief due to less enforcement, but meaningful regulatory change through legislation is looking like a long shot.
No longer a long shot are continued increases in the fed funds rate. Last week the Fed made it clear we are on the road to a normalization of interest rates. It’s happening. The Fed’s dot pattern shows an expectation of the fed funds reaching 3.0% in 2019. Nobody is surprised. Unemployment is lower, job creation is good and inflation is picking up. However, while we are currently pleased the economy is strong enough to warrant normalization, the end game is that the Fed will eventually want to cool economic growth to keep inflation in line.
FOMC participants’ assessments of appropriate monetary policy
Despite the disappointment over lower expectations for economic growth – the deferred hopes we mentioned above – this environment is really quite good for bond portfolios. A measured normalization of interest rates will gradually increase the income in fixed income portfolios with relatively low price volatility. We think it’s important to note that interest rates from 2 years to 30 years declined last week, even with the Fed raising the Federal Funds rate. Should normalization continue with long-term rates remaining range bound, this change will be appreciated after the last seven years of the Fed’s zero interest rate policy (ZIRP), delivering on hopes for higher income!
Source: The Federal Reserve, Bloomberg, The Financial Times, Bank of America Merrill Lynch