Be skeptical of all the Fed hype

You’ll likely see tempered U.S. Federal Reserve forecasts in early 2017, says John Braive, vice-chairman of Global Fixed Income at CIBC Asset Management, and manager of the Renaissance Canadian Bond Fund.

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“The Fed has talked about three rate hikes for 2017, whereas previously they had talked about two,” he says. “But going back a year ago when they first increased rates, they talked about four hikes for 2016—and we got one.”

For the following four reasons, Braive suggests taking a wait-and-see approach next year.

1. History may repeat itself.

After the first Fed hike in 2015, “economic prospects deteriorated during the year, and growth was not as strong globally as people had expected,” says Braive. “The Fed is now looking for a slight uptick in growth next year to 2.1%, previously at 2%, but that’s not a lot of extra growth.”

Plus, over the last couple of years, we’ve seen a slowdown in Q1. “We’ve had this variable [effect]—whether you call it a weather component or a slowdown—that has [consistently] occurred over the last couple of years in the first quarter. I wouldn’t be surprised if we have another slowdown in the first quarter of 2017 and people start revising their Fed calls.”

Also, “if [you] look at the Fed’s projections for items like the unemployment rate, down to 4.6% from 4.7%, as well as inflation,” there are few changes to its outlook.

2. Debt-to-GDP ratios have skyrocketed.

“One thing we’re [seeing]—and this is important to keep in mind—is that the level of debt out there is so much higher everywhere than it’s ever been,” says Braive. “If you look at the U.S. and Canada, or even at Europe and Italy and all of those places, debt-to-GDP ratios are way up in the stratosphere.”

He adds, “[Debt levels] came down in the U.S. a little bit with the recovery between 2009 and 2011, but [the debt-to-GDP ratio] has started to go up again and is at a new high.” Globally, “these ratios are also at a new high just about everywhere.”

As a result, Braive predicts a “very muted and constrained rate hike cycle. Because of the extraordinary amount of debt, it doesn’t take a lot for a rise in interest rates to impact spending patterns. I’m sure the Fed is very aware of this.”

3. Don’t forget about the aging population.

Says Braive, “You also have a demographic landscape in the U.S. that you’ve never had, and this is a risk.” As the U.S. population ages, that will likely affect productivity, the labour market and overall spending patterns.

4. What about the Fed’s balance sheet?

The other thing that’s really important is what the Fed does with its balance sheet, says Braive. “Through the quantitative easing buying program that they [have] had for Treasuries and mortgage-backed securities, [the Fed] has increased its balance sheet to $4 trillion. And there’s been no discussion yet about what they do with that balance sheet.”

But, he adds, “They will continue to reinvest maturing principal amounts back into the market, so that’s good for the market.”

Yesterday’s market reaction

The markets did react yesterday to the rate hike news: “We had 10-year bond yields go up to about 2.5% from about 2.4% in the U.S. And in Canada, bond yields were up to 175 from 170. But that’s not a [major] move,” says Braive.

The reason for this muted response, he says, is “the bond market has really been hammered and very oversold in our opinion. [The bond market] had discounted the bad news that was expected in this [Fed] statement, and we may be at the peak for interest rates for a while.”

He notes the curve — the difference between short rates right now and two-year rates — is anticipating a three-quarter-point increase in federal funds over the next year. “But again, we think that’s on the high side,” says Braive.