Fed relaxed on inflation not on the economy. The latest comments by Yellen suggest that the Fed is ready to keep interest rates low for longer to get productivity growth going, even at the cost of higher inflation. We believe real interest rates will become more negative as inflation expectations rise. Such an environment is likely to increase investors’ hunt for yield.Last Friday, Janet Yellen said the Fed may need to run a “high-pressure economy” – tighter labour market, higher consumption and investment – to reverse damage from the financial crisis, even at the cost of higher inflation. However, the economy is not yet overheating. The US economy has been adding 193k jobs per month on average so far this year without the unemployment rate edging lower and core PCE inflation rocketing higher. In our view, Yellen is not yet satisfied with the current level of employment and sees more room before it reaches its theoretical “maximum” level. Hence, she could slow the trajectory of interest rates as long as unemployment rate stagnates and inflation remains close to 2% (+/- 1pp).

Furthermore, the FOMC (Federal Open Market Committee) seems increasingly convinced of the existence of a “new normal” paradigm which requires lower benchmark rates than in the past. Fed’s Vice President Stanley Fischer stated that “gradual increases in the federal funds rate will likely be sufficient to get monetary policy to a neutral stance over the next few years.” Historically, the tightening cycles of the Fed resulted in an average of 380bps increase of the effective Fed Funds rate. Now, considering the shadow rate – a metric used to equate quantitative easing (QE) to an equivalent federal funds rate that is not bounded at 0% – the Fed already tightened its base rate by 337 bps since the end of the QE programme in November 2014, well before inflation started to pick up, and implies continued caution in raising rates.

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There will be two labour reports before the December meeting, and we believe that the FOMC will search for an acceleration of labour and inflation trends. We expect high volatility in the following months but the current state of the economy does not support a massive sell-off in fixed income as the FED tightens. Additionally, rising inflation breakeven rates will make real interest rates even more negative, and ultimately increase investors’ search for yield.

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Morgane Delledonne, Fixed Income Strategist at ETF Securities

Morgane Delledonne joined ETF Securities as Fixed Income Strategist in 2016. Morgane has an extensive experience in Monetary policy, Fixed Income Markets and Macroeconomics gained at the French Treasury’s Office in Washington DC and most recently in her role as Macroeconomist and Strategist at Pictet&Cie in Geneva. Morgane holds a Bachelor of Applied Mathematics from the University of Nice Sophia Antipolis (France), a Master of Economics and Finance Engineering and a Master of Economic Diagnosis from the University of Paris Dauphine (France).