Jefferies

Economics and Strategy

The Terminal Funds Rate

— David Zervos, Chief Market Strategist

On Wednesday June 14th, we got the fourth-rate hike of this cycle. And just as a reminder to all the folks who used to think the Fed could never raise rates again without sending us into a 1937-style second Great Depression – uh... that was a really dumb idea! But let’s not dwell on the past mistakes of the doomsday crowd; it’s time to move on to much more important subjects, such as finding a reasonable expectation of the terminal funds rate for this business cycle.

Now I could wax lyrical about what my state-of-the-art Dynamic Stochastic General Equilibrium model for the U.S. economy churns out for the equilibrium funds rate, but that would be a crock. Anyone who starts a sentence with “My model of the economy says...” loses me instantly (and they should lose you, too). So instead, I’m going to do what I usually do, which is to fall back on “informed economic heuristics” (aka storytelling) to provide my best guess at the answer to this question.

Let’s begin by revisiting the basic supply and demand shock concepts I put forth in a recent commentary, “Stagulation rules, stagnation drools.” In that piece I suggested that a large regulation-induced adverse supply shock had been responsible for much of the weak growth that has plagued our recovery. That supply shock caused output to be soft, inflation to remain robust, and capital investment to flee the U.S. In fact, as a side note, I would argue that the huge surge in Chinese investment that started in 2009 came from both demand AND supply forces. I have argued many times in past commentaries that when the Fed engaged in QE, it transmitted aggregate demand stimulus not just throughout the U.S. economy but also through the Chinese economy via the currency peg. And a rather healthy economy in China did not need such excessive stimulus. Of course, that set in motion what we all see today as an over-investment bubble. But what happened was not just about the QE/demand-side story. Our adverse regulatory supply side shock changed the relative global investment outlook in favor of China. This shift created a positive supply-side shock (or a positive relative cost-of-doing-business shock) for the Chinese. So in the end China got a double shot of stimulus from both the QE and regulatory increases in the U.S. No wonder the Chinese economy ripped from 2009 and is now in a highly fragile state. But I digress: This note is not about China; it’s about the U.S.

Now, if our regulation-induced negative supply shock starts to reverse in the U.S., as I have conjectured it will, what should happen? Well, growth should surprise on the upside; inflation should surprise to the downside; and relative investment decisions should begin to favor the U.S. And to be sure, this shift out in the Aggregate Supply (AS) curve will create a confusing picture for the Fed – especially since most folks within the institution don’t tend to believe in or focus on supply shocks. They will scratch their Phillips curve infused heads as employment, investment, and growth are robust while inflation fails to materialize. Further complicating matters, the Fed is on its fourth-rate hike, and they will likely intimate soon that the reinvestment of proceeds will start to taper by year-end. The Fed will be tugging the Aggregate Demand curve lower just as the AS curve is shifting out. The result will be a “double shot” of disinflationary pressure.

So where does this story leave us when we think about the Fed reaction function and the terminal funds rate for this cycle? Well, the Fed will likely keep trying to fit a demand-side square peg into a supply-side circular hole, if history is any guide. But in the end we need to make a simple determination: Will stronger growth and lower unemployment keep them hiking, or will the disinflationary pressures get them to slow the pace of future hikes? I am going to say the latter dominates, especially once the political motives of the current leadership structure at the Fed are removed in 2018.

So you can mark me down as supply-side-driven, low-terminal-funds-rate guy! What’s my number? I’m going to say 2.5% as a base case. The Fed will find supply-side-driven disinflation quite uncomfortable as we approach that level for the funds rate. And the risk at that point is the Fed may have overcooked the withdrawal of aggregate demand stimulus. You might then ask, how does this terminal rate position square with my view that real rates are headed back towards a more normal level of 2%? Easy, I just add in a very large risk premium for deflation – which is perfectly sensible given the deflation scares of the early and late 2000s. Investors will remain much more concerned about future reinvestment risks at low or negative rates, as opposed to being worried about having their cash locked up at a low rate in a potentially higher-inflation world. Investors will thus pay a premium to lock out deflation risks.

Here are the baseline numbers I have in mind for a breakdown of the terminal nominal funds rate into all of
its subcomponents:

  • Terminal nominal funds rate: 2.5%Terminal real funds rate (r*): 2%
  • Terminal inflation compensation: 0.5%
  • Terminal inflation expectations: 2%
  • Terminal “deflation” risk premium: -1.5%

The trading implications are clear. Higher real rates are still dollar-supportive, so I’m fine with our long USDJPY (dollar vs yen exchange rate) call. TIPS look extremely vulnerable in this scenario. And blues (bluepack of Eurodollar rate futures) look like a good value at current levels over 2%. More importantly though, this deregulation/low-terminal-funds-rate story has me thinking about going back to recommending my one true trading love: risk parity. Since Brexit I have not been able to get myself excited about spoos (S&P futures). Populism scared me. And today populism still scares me. On top of that, the Fed has been, and is still, hiking. Spoos and blues both felt vulnerable. However, thinking through the power of this deregulation trade on a “hedged” position with both spoos and blues is actually starting to get me a little giddy. I’m not 100% there yet, but I’m definitely ready to start flirting with this beauty again, especially as my confidence gains in these deregulation trends.