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Fed and rates

David Kotok is the chairman and chief investment officer of Cumberland Advisors. The views and opinions expressed in this piece represent only those of the author and not necessarily those of S&P Global Market Intelligence.

My colleague Bob Eisenbeis recently described the improved communications from the Fed and offered his current thoughts on Fed policy. His post-Fed-meeting notes are here.

Today we want to take a longer view of interest rates and offer some observations on what lies ahead. I write this after the Federal Open Market Committee June meeting and after I was fortunate to participate in a panel at the Benchmark Rates Forum New York 2018. That June 7 meeting brought together major players from around the world for sequential presentations about the coming changes in short-term interest rates and about the replacement for LIBOR. I thank Alexandre Ripley for inviting me to speak at this prestigious gathering. And I also thank KPMG, Bloomberg and Latham & Watkins for sponsoring the day-long event.

One major forecast of shorter-term interest rates has suggested what rates will be in December 2019. The year-and-a-half time frame is not so long, but that forecast required considerable effort to develop a rationale behind each item. Let me extract and comment on what is a substantial, 60-plus-page document.

The forecast projects the upper end of the fed funds band to be 3.50% by December 2019. Remember that the fed funds rate-setting mechanism now operates with a high/low band for the FOMC target. The forecast calls for the lower end of the band to be 3.25%, which is also the expected RRP rate. This is the rate that is thought to reflect the use of repo, which is an alternative form of short-term interest rate cash management for those institutions that may not have direct access to the Federal Reserve. So the forecast target range is 3.25% to 3.50% at the end of 2019.

Interest that the Fed will pay on excess reserve deposits (IOER) is projected at 3.45%. This is five basis points lower than the upper band and is the extension of a new Fed policy that was announced at the June meeting. The Fed is trying to keep the fed funds rate within the targeted band. It faced a problem in that the fed funds rate was pushing against the upper end of the band for a variety of reasons. So the Fed raised the band by 25 basis points but raised the IOER rate by only 20 basis points. The 2019 forecast sees that policy decision continuing for the next year and a half.

The forecaster then estimated the rest of the short-term interest rates as follows. Treasury bills and related collateral would trade at 3.40%. SOFR, or the secured overnight funding rate, would trade at 3.35%. That would put one-month LIBOR at 3.60% and three-month LIBOR at 3.75%. The spread between LIBOR and the overnight indexed swap, or OIS, is expected to be 30 basis points, and this estimate assumes that no shocks or credit problems rock the banking system and that LIBOR is fully functional.

Let's think about what interest rates in the marketplace would look like if this forecast turns out to be correct.

As an investor, your cash-equivalent options should be somewhere in the neighborhood of 3% or slightly lower. That is a major change from the last 10 years. We believe that is a rate high enough to change investor behavior and to restore the holding of some cash reserves by those investors who have been seeking to do so.

What can we expect for intermediate and longer-term rates if this forecast is correct? Here is where things get really difficult.

If the short-term and overnight SOFR is yielding 3.35%, is it reasonable to expect the intermediate and longer-term riskless U.S. Treasury note and bond to yield less? That would mean an inverted yield curve, and that outcome is hard to see if there is a growing U.S. economy. If there is a recession, it is hard to see how the Fed would have raised rates high enough to meet the forecast expectations.

So either we have to disagree with this forecast, or we have to raise the expectation for the 10-year Treasury yield to reach somewhere around 4%. We can quickly see what that figure does to mortgage interest rates and corporate bond rates and also to municipal bonds rates, although they are not likely to respond as much as corporate rates will.

Other forces are also at work and will influence the Fed. What happens to the unemployment rate over the next year and a half, and what happens to the inflation rate? The former is headed lower to about 3.5%, while the latter is headed higher. Are they on a collision course?

And lastly, what will be the impact when the European Central Bank starts to move away from its negative-rate targets and tapers its bond-buying program? And let's not ignore the expanding U.S. federal deficit and the Fed's policy of shrinking the size of its asset holdings by allowing maturity and not replacing federally backed debt instruments. There is also the nascent trend of the Social Security Trust Fund's rolling over, which means a transfer to the market to absorb the change. It isn't much now, but it will be a growing force over time if the Congress doesn't remedy the Social Security funding formula. Since Congress is usually reactive and requires a crisis to act, we are not sanguine about an early fix to Social Security.

Cumberland now uses a barbell strategy in its actively managed bond accounts. It does so for a very important reason. The strategy allows bond management to proceed when there are headwinds facing the bond market. Barbells are called for now. Ladders are likely to underperform. That is true for both taxable and tax-free bond accounts. And credit quality surveillance is a critical and ongoing need.

The next two years are going to be interesting and challenging.