Pacific Funds, june 2018
Informational commentary from Pacific Asset Management, manager of Pacific FundsSM Fixed-Income Funds.
As expected, the Federal Open Market Committee (FOMC) voted to raise the range of the federal funds target rate to between 1.75% and 2.00%, citing strong job growth, a pickup in consumer spending, and inflation close to goal. While the rate increase was fully priced in prior to the decision, the Committee took a more hawkish tone than market participants expected, now signaling two additional hikes in 2018. There were no major changes to the median estimates for gross domestic product (GDP). Of note, however, were an increase to inflation and decreases to unemployment as summarized below. There were important changes to the language in the FOMC statement, which are noted below.
- The FOMC raised the range for the federal funds target rate to between 1.75% and 2.00%.
- Language changes in the June statement versus the May statement (shown in italics):
- Economic activity has been upgraded to rising at a solid rate, versus at a moderate rate (hawkish).
- The unemployment rate has declined, versus stayed low (hawkish).
- Household spending has picked up, versus moderated (hawkish).
- Adjusted “further gradual increases in the target range for the federal funds rate will be consistent with sustained expansion of economic activity, strong labor market conditions, and inflation near the Committee’s symmetric 2 percent objective over the medium term,” versus “with further gradual adjustments in the stance of monetary policy, economic activity will expand at a moderate pace in the medium term and labor market conditions will remain strong.”
- Emphasized (again) the inflation goal as a “symmetric 2 percent inflation objective” as it relates to the timing and size of further increases in the target range. Again, providing flexibility should inflation temporarily move above the inflation goal. This was done in conjunction with eliminating forward-guidance language for some time in reference to the federal funds rate staying below longer-run levels (hawkish).
In addition, the Committee voted unanimously to raise the interest rate paid on required and excess reserve balances to 1.95%, an increase of 20 basis points (1 basis point is equal to 0.01%), effective June 14, 2018, stating: “Setting the interest rate paid on required and excess reserve balances 5 basis points below the top of the target range for the federal funds rate is intended to foster trading in the federal funds market at rates well within the FOMC’s target range.”
- Median expectations for the dot plots now suggest a target rate of 2.375% for 2018 (two additional hikes), 3.175% in 2019 (three additional hikes), 3.375% in 2020, and 2.875% for the longer run.
- The change in median expectations for two additional hikes in 2018 (March expectations were for one more in addition to a June hike) was simply the result of one vote moving higher by 25 basis points.
- Economic projections were mixed, with real GDP revised modestly higher by 0.1% to 2.8% in 2018 and unchanged at 2.4%, 2.0%, and 1.8% for 2019, 2020, and the longer run.
- Unemployment rates have been revised downward to 3.6% in 2018, 3.5% in 2019 and 2020, and maintained at 4.5% for the longer run, respectively.
- Inflation as measured by the core personal consumption expenditures (PCE) price index was increased to 2% for 2018 (from 1.9%), and maintained at 2.1% for 2019 and 2020.
- Federal funds futures, as forecast by Bloomberg, currently show an 83% chance of an interest-rate hike to be announced in the September 2018 meeting and 94% in the December 2018 meeting.1
- There were no dissenting votes.
While the decision was largely priced into the markets, the yield curve continued to flatten as the Committee signaled a steeper path of tightening ahead. Following the decision, the spread between the 5-year U.S. Treasury note and the 30-year U.S. Treasury bond, as well as the spread between the 2-year and 10-year U.S. Treasury yields, fell to the narrowest levels since 2007, raising concerns of an inversion of the yield curve. This concern arises as an inverted yield curve, where short-term interest rates yield more than long-term interest rates, has correctly predicted the last seven recessions dating back to the 1960s. Of note, however, is that in these previous instances, quantitative easing had not taken place, resulting in a technical dynamic that influences this spread.
Further language changes in the meeting notes, which cite a focus on the federal funds rate as the primary tool to tighten monetary conditions and may increase the likelihood of the curve inverting, whereas normalizing the balance sheet could tighten conditions and increase higher longer-end rates. Despite higher short-term interest rates, financial conditions remain accommodative as measured by the Chicago Federal Reserve’s National Financial Conditions Index (NFCI), giving the Fed the ability to continue to normalize rates until they influence the economy.
While the stronger U.S. dollar should dampen inflation, Chairman Jerome Powell notes that we have yet to see the impact of trade policy on import inflation, which is a potential headwind. Also of note, Powell announced plans to hold a press conference at every meeting (versus every other meeting) beginning in January 2019.
This past week has been full of potentially market moving events: the Singapore Summit, FOMC, AT&T ruling, and other global central-bank meetings, each with the potential to alter the outlook for global growth and stimulate markets. That said, the news from these events has largely gone as expected. Given an absence of a change in fundamentals, our approach is to continue “staying the course.”
1Bloomberg Finance L.P., 6/13/18.
Core personal consumption expenditures (PCE) price index is the Fed’s preferred measure of U.S. inflation, which measures the prices consumers pay for goods and services without the volatility caused by energy and food prices.
A dot chart or "dot plot" is a statistical chart consisting of data points plotted on a fairly simple scale used to project the rate path.
Dovish refers to an indication the Fed may lower interest rates.
Hawkish refers to an indication the Fed may raise interest rates.
The Chicago Federal Reserve’s National Financial Conditions Index (NFCI) provides a complete weekly update on U.S. financial conditions in money markets, debt and equity markets, and the traditional and “shadow” banking systems.
This publication is provided by Pacific Funds. Pacific Funds refers to Pacific Funds Series Trust. This commentary reflects the views of the portfolio managers at Pacific Asset Management as of June 13, 2018, are based on current market conditions, and are subject to change without notice. These views represent the opinions of the portfolio managers and are presented for informational purposes only. These views should not be construed as investment advice, an endorsement of any security, mutual fund, sector, or index, the offer or sale of any investment, or to predict performance of any investment. Any forward-looking statements are not guaranteed. All materials are compiled from sources believed to be reliable, but accuracy cannot be guaranteed.
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Pacific Life Insurance Company is the administrator for Pacific Funds. It is not a fiduciary and therefore does not give advice or make recommendations regarding insurance or investment products.
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