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Komson: Thank you for joining us for this edition of asset allocation perspectives. Today we're going to talk about one of the biggest drivers and markets in recent years: Fed policy. Since December 2015 the Fed has embarked on a rate hiking cycle, hiking seven times since then, and the market is pricing in three more hikes through the end of 2019, at which the Fed is expected to pause. Today we're going to talk about the three factors that cause a Fed to be more accommodative and dovish, which means hiking less than the expected three times through 2019, or more hawkish and more aggressive, meaning hiking more than three times through 2019.

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The first factor as to why the Fed could be more dovish is a potential inversion the yield curve. Now one way to look at the yield curve is as a spread between a long rate, which we define as the 10-year or longer, so the 10-year minus a short rate, which could be the two-year. And so the 10-year versus two-year’s spread is currently .21%, and an inverted yield curve -- that spread below zero -- typically precedes the recession by about 18 months. Fed officials have recently voiced caution on this measure, and that could cause a more dovish policy. The second factor as to why the Fed could be more dovish is EM (emerging markets) stress. Now in this in this environment of low interest rate policy, EM economies and foreign economies have borrowed at low interest rates in U.S. dollars. As interest rates rise, and as the U.S. dollar gets stronger, those funding costs go up, which cause stress in emerging markets. We're seeing a little bit of that today. The third factor is potential fall off from trade tensions. Now, retaliatory tariffs between the U.S. and China could result in higher business uncertainty, a hit to the supply chain, and tighter credit. And so to the extent that those factors affect the U.S. economy, the Fed could slow policy.

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The first factor as to why the Fed could be more hawkish and aggressive with future rate hikes is strength in the U.S. economy. The U.S. economy grew at above 4% for the second quarter and is expected to the grow at over 3% for the year in 2018. Now, the Fed could be more aggressive in hiking rates in order slow a potentially overheating economy. The second factor has to do with that as well, rising wages in a tight labor market. Now, there's no doubt that the labor market’s very healthy right now -- unemployment rates below 4%, wages are rising at 2.9% a year clip, which is the highest really post-crisis. And so labor costs going up could affect corporate margins. And so I think the Fed could be more aggressive in slowing those rising costs and rising inflation. Another factor is inflation due to tariffs. Now, retaliatory tariffs between the U.S., China, and other trading partners results in higher goods prices. And to the extent that these tariffs don't affect the economy in a negative way, the Fed could respond by tightening more than market has discounted.

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So what do we think is going to happen? We're in the “three hikes or less” camp through 2019 given a flattening yield curve, potential stresses and EM funding, and subdued inflation. With that in mind, we think that rates are not going to rise materially over the next three to six months if financial assets such as equities continue to be supported. Thanks for joining us for this edition of asset allocation perspectives.

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Disclosures

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