December 12, 2016 FED BRIEF - Capital One...December 12, 2016 | FED BRIEF 3 No part of this document may be reproduced in any manner without written permission from Capital One’s

December 12, 2016 | FED BRIEF 1

FED BRIEF

December 12, 2016

No part of this document may be reproduced in any manner without written permission from Capital One’s Wealth and Asset Management Group. For full disclosures, see last page of document.

PROFITABLE RISKS / SM

UNPROFITABLE RISKS

Loss avoidance is a key to long term investment success. We deem certain risks profitable, to be exploited with sound research, while other risks are inherently unprofitable and should be avoided.

OUR RISK MANAGEMENT TENETS

A rigorous top-down approach toforecasting liquidity conditions is

an essential ingredient in fixed-income risk management

Active management of interest rate risk within modest limits is a cornerstone of successful fixed income portfolio management

Extreme variation from bench-mark duration is counter-productive

Yield curve, sector positioningand careful employment of creditrisk offer attractive cyclicalopportunities to add relativevalue

Opportunistic and modest em-ployment of high yield andinternational debt elements canadd significant value to a coreinvestment grade mandate

FED LOCKED AND LOADED Paul Teten, CFA© Chief Investment Officer December 12, 2016

Market eyes are focused on the Federal Open Market Committee’s (FOMC) meeting this week, and the post-meeting press conference on Wednesday, at which Chair Janet Yellen will expound on the 2017 policy outlook and update the committee’s economic projections for next year. Most Fed observers uniformly expect the FOMC to announce a 0.25% increase in the Fed Funds rate on Wednesday, a culmination of the most orchestrated and publicly deliberated policy change in the history of the Fed. That will put the Fed Funds policy range at 0.50-0.75% and Funds should trade mostly around the mid-point, about 0.63%, up from 0.38% today. That’s a far cry from the FOMC projection of 1.38% for December 2016 foretold a year ago, when the Fed launched the first increase in the Fed Funds rate since cutting it to near-zero in December 2008.

It didn’t take long for the markets to indicate concern that the Fed was moving in an untenable direction a year ago. The U.S. stock market peaked in late December and global markets swooned in January and February, recoiling from a number of fears, including falling oil prices, deflationary concerns in Asia, slowing global growth; with the Fed seeming oblivious to the danger in raising rates in that environment. As the successive FOMC meetings approached in March, April and June, the inflation hawks on the committee would publicly talk a strong game on the need to normalize monetary policy; leaving Yellen to attempt to explain why the committee chose caution in not moving the Funds rate up, essentially deferring to market stability. Finally, in September, as incoming data on the U.S. economy looked better but not consistent enough, the FOMC expressed confidence that conditions would shortly warrant a rate increase, just not quite yet. The markets interpreted this stance as a “hawkish hold”, intended to guide expectations to a rate increase in December, a guidance that has been repeatedly buttressed in public statements throughout the fall. The cost in lost credibility for the Fed in not moving the Funds rate up this week would be enormous, and in itself sufficient grounds for high confidence the Funds rate will trade at 0.63% by the end of the week.

The Fed’s timing is good for once as the macroeconomic and market environment is supportive of a Fed move as well. Economic growth is better than it was in the spring and summer, when recession risks had risen uncomfortably high. Employment growth is above average, not great, but modestly better. Importantly, since Donald Trump’s win on November 8, the markets are looking far ahead to better growth in a Trump administration and dismissing the crummy economic environment that has persisted since 2009 as history. Inflation rates aren’t much changed but inflation expectations have moved up on the assumption that stronger economic growth next year will drive inflation higher relatively soon. This would seem a questionable assumption given substantial global excess capacity for goods



production and the consequent stubbornness of lackluster goods prices for many years, but nevertheless the markets are giving the Fed a pass on low inflation. The U.S. stock market has rallied to new highs, already high valuations are higher, attitudes are getting exuberant. The Treasury Bond market has priced in a 0.25% increase in the Funds rate this week and another increase or two next year. The market is saying go for it.

More important than the 0.25% rate increase this week will be what light Mrs. Yellen sheds on FOMC expectations for 2017 and longer-term. Committee projections for out-year Fed Funds targets have become progressively more realistic since the first increase a year ago, when the FOMC confidently predicted that the Funds rate would trade at 1.38% by now. Last December, the FOMC projected the Funds Rate would trade at 2.37% in December 2017 and 3.25% in December 2018. Those projections were reduced at the recent September meeting to 1.13% and 1.88%, respectively; reflecting the Fed’s dramatically reduced appraisal of their ability to raise rates in the continuing sluggish global growth conditions. The U.S. Treasury 2-year note is trading in agreement with the December 2017 projection, also trading at 1.13%, in anticipation of a 0.50% increase in the Funds rate in 2017. Traders will be paying close attention to these so-called dot-plots on Wednesday.

In addition to the year-end projections, the FOMC also exhibits its estimate for the longer-term “normal” Fed Funds rate. The Fed tries to avoid making reference to complex theories of equilibrium interest rates in its public projections, but that is what long-term normal is grounded in, that theoretical Funds rate that is neither tight nor easy money; the Goldilocks rate that neither encourages excess savings nor excess spending. The FOMC’s projection for the long-term normal Funds rate has declined sharply in recent years, as the accompanying graph depicts. Estimated at 4.0% as recently as 2014, the long-term normal Funds rate estimate has been guided sharply lower in recent years, down to 2.88% in September. It will be interesting to see on Wednesday if the long-term normal estimate is stable at 2.88%, or increases; presumably as a result of the Trump euphoria that has guided economic and inflation expectations higher since November 8.

CURRENT RISK ASSESSMENTS

Duration strategies modestly longv. benchmarks

ATTRACTIVE SECTORS: 5-7 Yr Treasuries for optimum

roll-down returns Investment grade Finance credits Super-senior commercial

mortgage-backed securities Short duration high-yield

corporate bonds High quality Municipals with no

pension funding challenges

UNATTRACTIVE SECTORS: Emerging Market credit and

currency exposure Developed Market credit

exposure Long duration high yield

corporate bonds

Source: Bloomberg, Federal Reserve, September 21, 2016



When Chair Yellen or other FOMC members speak publicly to the effect that the extent of monetary accommodation has turned out to be less than they thought, meaning near-zero interest rates are not as stimulative as they expected, they are referring to the spread between the actual Funds rate and the theoretical equilibrium rate. As their estimate for the long-term normal rate has come down, the suggestion is that the actual Funds rate turns out to be not as far below the equilibrium rate as they once thought. Another way to say this is the frequently heard assertion that financial conditions have tightened, even though short-term interest rates have barely risen.

Our expectation is that the downward drift in the long-term normal estimate will continue, even if temporarily suspended this week. No one knows for sure where the equilibrium Funds rate is, however it strikes us as imminently reasonable that it should be roughly equivalent to the recent trend in price inflation as measured by the core inflation rate, the Fed’s preferred measure being the personal consumption expenditure deflator, ex food and energy, year-to-year rate of change. More precisely, it should be about the same as inflation expectations, and both the core inflation trend and the Fed’s 5-year forward expected inflation rate have both trended around 1.5-1.7% this year. Since November 8 the expected inflation gauge has risen to 1.9% on the strength of stronger growth expectations from a presumed Trump agenda.

Since the Fed’s first rate increase this cycle last year our expectation has been that the Fed would try to move the Fed Funds rate up to even with the core inflation rate. The market is now pricing Fed Funds futures in December 2018 at 1.47%, which is getting close to what core inflation is now, although it may be higher two years out. The Fed’s inflation target is 2% so we will stipulate that eventually the FOMC will want to move the Funds rate up to 2%. A 2% Funds rate with 2% inflation means that the real, inflation-adjusted, Funds rate is zero, which we think qualifies as an equilibrium funds rate in this sluggish growth cycle.

Our assessment is that Fed’s estimate of the long-term normal Funds rate will continue to drift lower toward 2%, which is a better estimate of the equilibrium rate than the current estimate of 2.88%. Mrs. Yellen has discussed the likelihood that the equilibrium Funds rate is not a constant but moves up and down with economic conditions. Our current low inflation and sluggish growth economy implies a low equilibrium rate, but in a stronger cycle the equilibrium rate would be expected to be higher. Thus we expect to see more movement in the long-term normal Funds rate estimate as the FOMC gets more comfortable with the measure as a proxy for the equilibrium rate.

If we ever do get a stronger economic climate, when the Fed sees the need to move to restrain inflationary pressures, we will expect to see the Funds rate move 1-2%, or more, above the long-term normal rate. That’s a highly improbable prospect at this point, though. The corollary is that if the bond market concluded that the Fed was inadequately addressing clear and present inflation risks, it would force the Fed to act by pushing long-term interest rates higher.


European Central Bank

The European Central Bank (ECB) met last week and reported that it would extend its quantitative easing program to year-end 2017 from its initially scheduled termination in March. The program to purchase Euro-denominated government and non-financial corporate bonds has been executed at a pace of € 80 Billion per month, however beginning in April the program will be trimmed to € 60 Billion per month. Chairman Mario Draghi labored to avoid calling the extended program a tapering, emphasizing the significantly expanded monetary stimulus. Draghi reiterated prior assurances that the ECB would aggressively support European economic recovery and a modest acceleration in inflation as necessary. After an hour or so of knee jerk reactions to the hint of diminished stimulus, markets settled down and essentially took Draghi at his word that tapering was not his priority. Notably the Dollar rallied sharply against the Euro, which would certainly have been the reverse if tapering had been the emphasis.

The ECB’s dilemma, evident in recent months, is that the liquidity provision has been counter-productive and has not stimulated growth or inflation as projected; but any discussion of phasing the program out, which will inevitably be referred to as tapering, could easily provoke a riot in global bond markets and drive interest rates higher. Tapering is a reference to the “taper tantrum” in the U.S. in 2013 when former Fed Chairman Ben Bernanke first broached the likelihood that quantitative easing would be phased out, which promptly drove long Treasury yields up by 1.5%.

Britain’s planned exit from the European Union (EU), known as BREXIT, has complicated the ECB’s task in contemplating an end to its extraordinary stimulus while simultaneously not wishing to destabilize economies that have generally not recovered well from the 2008-2011 crisis. The populist element that swung the surprise BREXIT vote, echoed in the U.S. in the Trump victory, is also evident in several other countries in Europe, casting a pall of disunity over the Union. The failure of the Italian referendum last week, which would have improved national governance, is seen as a populist rejection and reflection of dissatisfaction with the EU in Italy. Parliamentary elections in the Netherlands in March are also seen to have a strong Euro-skeptic element that may result in an anti-EU statement. Parliamentary elections will occur in France and Germany later in the spring, with the British exit an irritant factor in both. The ECB’s monetary policy goals are likely to continue to be constrained to emphasize stability over better policy as national elections play out across the continent next year.

Trump and the Fed

Donald Trump was stridently critical of the Federal Reserve in general and Chair Yellen in particular during the campaign, suggesting that the Fed was tacitly supporting the Clinton campaign through an excessively easy monetary policy. The charge was highly unusual in Presidential politics, which historically have avoided politicizing the Fed, as there has traditionally been a strong bi-partisan consensus that an independent Fed is essential to good governance. Mr. Trump said many ''''''''



things in the campaign that in hindsight seemed more intended to stir populist fervor than accurately describe a problem. Accusing China of being a currency manipulator comes to mind in that regard. Given that the President-Elect has put together a respectable team of seasoned economic and policy experts, we have reason to hope that he will see the wisdom in giving the Fed the wide berth it deserves in its policy deliberations.

Mr. Trump will however, have the opportunity to shape the Fed through appointment of Governors for two open seats and leadership terms will be up for reappointment in 2018. The Fed’s charter mandates seven Governors, two of which are currently open seats, with only one of the other five expiring during Mr. Trump’s term, that being of Stanley Fischer, whose term expires in the fourth year of the Trump presidency in January 2020. Importantly though, Janet Yellen’s Chairmanship will expire in February 2018 and Fischer’s Vice-Chairmanship expires in June 2018. So Mr. Trump will be able to effect a significant remolding of the Fed over the next 18 months. Hello Larry Kudlow!



No part of this document may be reproduced in any manner without written permission from Capital One’s Wealth and Asset Management Group. For

Un less otherwise noted, all return data sourced fr om Bloomberg, LP, November 30, 2016.

Disclosures For informational purposes only. Neither the information nor any opinion expressed in this material constitutes an offer to buy or sell any security or instrument or participate in any particular trading strategy. Capital One, N.A., its affiliates and subsidiaries are not providing or offering to provide personalized investment advice through this communication, or recommending an action to you. Capital One, N.A., its affiliates and subsidiaries are not acting as an advisor to you and do not owe a fiduciary duty to you with respect to the information and material contained in this communication. This communication is not intended as tax or legal advice; consult with any and all internal or external advisors and experts that you deem appropriate before acting on this information or material. Wealth and Asset Management products and services are offered by Capital One, N.A. (“Bank”). All investment management clients are clients of the Bank, who has delegated the investment management services to Capital One Asset Management, LLC (COAM) via a master services agreement. Investment management services are provided to the Bank by COAM, a SEC registered investment advisor and wholly-owned subsidiary of Capital One, N.A. © 2016 Capital One. All rights reserved. COAM registered with the SEC in 2001 as a Registered Investment Adviser as a Separately Identifiable Division or Department (“SIDD”). In 2005, COAM changed its registration to a wholly owned subsidiary when it filed with the State of Louisiana as a Limited Liability Company. Please refer to COAM’s ADV Part 2, which is available upon request, for additional information on COAM.Recipients of this report will not be treated as a client by virtue of having received this report. No part of this report may be redistributed to others

or replicated in any form without the prior consent of Capital One. All charts and graphs are shown for illustrative purposes only. Opinions, estimates, forecasts, and statements of financial market trends that are based on current market conditions constitute our judgment and are subject to change without notice. The information has been obtained from sources believed to be reliable but we do not warrant its completeness, timeliness, or accuracy, except with respect to any disclosures relative to Capital One. The information contained herein is as of the date referenced, and we do not undertake any obligation to update such information.Any opinions and recommendations expressed herein do not take into account an investor’s financial circumstances, investment objectives, or financial needs and are not intended for advice regarding or recommendations of particular investments and/or trading strategies, including investments that reference a particular derivative index or benchmark. Past performance is not indicative of future results. The securities described herein may be complex, may involve significant risk and volatility, may involve the complete loss of principal, and may only be appropriate for highly sophisticated investors who are capable of understanding and assuming the risks involved. The securities discussed may fluctuate in price or value and could be adversely affected by changes in interest rates, exchange rates, or other factors. Asset allocation and diversification do not assure or guarantee better performance, and cannot eliminate the risk of investment losses. Investors must make their own decisions regarding any securities or financial instruments mentioned or discussed herein, and must not rely upon this report in evaluating the merits of investing in any instruments or pursuing investment strategies described herein. In no event should Capital One be liable for any use by any party, or for any decision made or action taken by any party in reliance upon, or for any inaccuracies or errors in, or for any omissions from, the information contained herein. Fixed Income securities are subject to availability and market fluctuations. These securities may be worth less than the original cost upon redemption. Corporate bonds generally provide higher yields than U.S. treasuries while incurring higher risks. Certain high yield/high-risk bonds carry particular market risks and may experience greater volatility in market value than investment-grade corporate bonds. Government bonds and Treasury bills are guaranteed by the U.S. government and, if held to maturity, offer a fixed rate of return and fixed principal value. Interest from certain municipal bonds may be subject to state and/or local taxes and in some circumstances, the alternative minimum tax. Unlike U.S. Treasuries, municipal bonds are subject to credit risk. Quality varies widely depending on the specific issuer. Yields are subject to change with economic conditions. Yield is only one factor that should be considered when making an investment decision.

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December 12, 2016 FED BRIEF - Capital One...December 12, 2016 | FED BRIEF 3 No part of this document may be reproduced in any manner without written permission from Capital One’s