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  • 7/28/2019 The Federal Reserve Dont Let It Be Misunderstood

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    Investment Management Division

    This material represents the views of the Investment Strategy Group (ISG) in the Investment Management Division of Goldman Sachs. It is not a p roduct of Goldman Sachs Asset Management (GSAM) or

    Goldman Sachs Global Investment Research. The views and opinions expressed herein may differ from those expressed by other groups of Goldman Sachs.

    Investment Strategy Group

    The Federal Reserve: Dont Let It Be Misunderstood

    June 26, 2013

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    Investment

    Management

    DivisionTodays Call

    2

    Recent Financial Markets Performance

    Interpreting the Federal Reserves Commentary

    Implications for Financial Markets

    China: A Confluence of Events Fueling the Fire

    Key Takeaways

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    Investment

    Management

    DivisionGreat Market MomentumUntil Recently

    3

    1. Asset Class Returns: Dec. 31, 2012 S&P 500 Peak Close (May 21, 2013) 2. Asset Class Returns: S&P 500 Peak Close (May 21, 2013) June 25, 2013

    Source: Investment Strategy Group, Datastream

    (1) Indices used: Barclays US Corporate High Yield for US Corp High Yield, Barclays High Yield Munis for HY Muni, Barclays US High Yield Loans for HY Bank Loans, MSCI Indices for

    EM and Chinese equities, JP Morgan GBI-EM Global Diversified Index for EMLD and Gold Bullion LBM for Gold.

    -1.0%

    -4.7% -4.8%

    -6.7%

    -8.3%

    -9.5% -9.7%

    -11.6%

    -15.3%

    -18%

    -16%

    -14%

    -12%

    -10%

    -8%

    -6%

    -4%

    -2%

    0%

    HY BankLoans

    S&P 500 US CorpHigh Yield

    Gold HY Muni EuroStoxx 50

    EMLD EMEquities

    ChineseEquities

    18.0%

    10.0%

    5.4%3.9% 3.4%

    2.1%1.2%

    -1.2%

    -17.8%-20%

    -15%

    -10%

    -5%

    0%

    5%

    10%

    15%

    20%

    S&P 500 EuroStoxx 50

    US CorpHigh Yield

    HY Muni HY BankLoans

    EMEquities

    EMLD Chines eEquities

    Gold

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    Investment

    Management

    DivisionKey Driver of Markets Recently: Taper Timetable

    4

    US 10-Year Treasury Yields Around Major Events in 2013 (Through June 25, 2013)

    Source: Investment Strategy Group, Datastream

    April EmploymentReport (May 3)

    FOMC MeetingMinutes Releasedand CongressionalTestimony "Taper"

    (May 22)

    FOMC Statementand Bernanke Press

    Conference(June 19)

    2.55

    1.6

    1.7

    1.8

    1.9

    2.0

    2.1

    2.2

    2.3

    2.4

    2.5

    2.6

    Jan-13 Feb-13 Mar-13 Apr-13 May-13 Jun-13

    Recent FOMC commentary introducing the possibility of tapering later this year pushed yields above their

    YTD range.

    The 10-year Treasury is now down 5.5% YTD on a total return basis, down 3.2% since June 19 and a total

    drawdown of 7.6% since early May.

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    Investment

    Management

    DivisionFederal Reserve Commentary Reverberations

    5(1) This is a proxy measure for the 5-year Treasury yield based on the swap market.

    Source: Investment Strategy Group, Datastream

    1. ForwardImplied Short Rate Curve (3 Month Rate)

    0.0%

    0.5%

    1.0%

    1.5%

    2.0%

    2.5%

    3.0%

    3.5%

    4.0%

    4.5%

    13 14 15 16 17 18

    As of May 21st (Day Prior to FOMC Minutes and Testimony)

    As of Jun 25th

    The market now expects the FOMC to raise interest rates earlier.

    Moreover, 5-year interest rates are expected to normalize faster than previously thought.

    2. US 5-Year Treasury Yield 5 Years Forward1 (Through June 25, 2013)

    2.88

    4.14

    2.0

    2.5

    3.0

    3.5

    4.0

    4.5

    5.0

    5.5

    6.0

    2010 2011 2012 2013

    Percen

    tagePoints

    +126

    bps

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    Investment

    Management

    DivisionUS Equity Volatility has not Matched the Increase in Rates

    6Source: Investment Strategy Group, Federal Reserve.

    VIX (S&P 500 Implied Volatility) Through June 25, 2013

    18.5

    24.7

    15.0

    15.0

    0

    10

    20

    30

    40

    50

    60

    70

    80

    90

    2008 2009 2010 2011 2012 2013

    VIX Average 50-Day Moving Average 200-Day Moving Average

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    Investment

    Management

    Division

    Interpreting the Federal Reserves Commentary:

    Congressional Testimony and FOMC Minutes (May 22)

    7(1) Represents the views of the Investment Strategy Group.

    Source: Investment Strategy Group, Reuters, Federal Reserve, C-SPAN.

    Chairman Ben Bernanke's Testimony

    Dovish1

    Hawkish1

    A prem ature tightening of monetary

    policy could lead interest rates to rise

    temporarily but would als o carry a

    substantial risk of slowing or ending

    the economic recovery and causing

    inflation to fall further. To this point oursense is that major asset prices like

    stock prices and corporate bond

    prices are not inconsistent with the

    fundamentals.

    If we see continued im provement and

    we have confidence that that's going to

    be sus tained then we could in the next

    few meetings ... take a step down in

    our pace of purchases.

    Minutes from April/May FOMC Meeting

    Dovish1 Hawkish1

    However, economic data releases over

    the intermeeting period were mixed,

    raising s ome concern that the recovery

    might be slowing after a solid start

    earlier this year, thereby repeating the

    pattern observed in recent years.

    continued progress, more

    confidence in the outlook, or

    diminished downside risks would be

    required before slowing the pace of

    purchases would become appropriate.

    A number of participants expressed

    willingness to adjust the flow of

    purchases downward as early as the

    June meeting

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    Investment

    Management

    Division

    Interpreting the Federal Reserves Commentary:

    Chairman Bernankes Press Conference (June 19)

    8(1) Represents the views of the Investment Strategy Group.

    Source: Investment Strategy Group, Federal Reserve, C-SPAN.

    Chairman Ben Bernanke

    Dovish1

    Hawkish1

    The Comm ittee expects a

    considerable interval of time to pass

    between when the Comm ittee will

    cease adding accommodation through

    asset purchases and the time when

    the Comm ittee will begin to reduceaccomm odation by moving the federal

    funds rate target toward more normal

    levels.

    If the incoming data are broadly

    consis tent with this forecas t, the

    Comm ittee currently anticipates that it

    would be appropriate to moderate the

    monthly pace of purchases later this

    year.

    However, any need to cons ider

    applying the brakes by raising short-

    term rates is still far in the future.

    And if the subsequent data remain

    broadly aligned with our current

    expectations for the econom y, we

    would continue to reduce the pace of

    purchases in m easured steps through

    the first ha lf of next year, ending

    purchases around midyear.

    When as set purchases ultimately

    come to an end, the unemployment

    rate would likely be in the vicinity of 7

    percent.

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    Investment

    Management

    DivisionCommentary From Other Fed Officials (June 24)

    9

    Source: Investment Strategy Group, Bloomberg, The Wall Street Journal, The Financial Times, Global Post, Federal Reserve Bank of Minneapolis.

    (1) Excerpts from his speech at a conference at the Official Monetary and Financial Institutions Forum on June 24, 2013.(2) Excerpts from Statement: Recent FOMC Communications as a Part of Appropriate Monetary Policy, published by the Minneapolis Fed June 24, 2013.

    (3) Represents the views of the Investment Strategy Group..

    Richard Fisher

    (President of the Federal Reserve Bank of Dallas,

    Non-Voting Member of the FOMC)1

    Narayana Kocherlakota

    (President of the Federal Reserve Bank of Minneapolis,

    Non-Voting Member of the FOMC)2

    Dovish3 Hawkish3 Dovish3 Hawkish3

    I'm not in favour of going from Wild

    Turkey to cold turkey over night

    It would be appropriate for us to dia l

    back the monetary stimulus.

    The Committee shou ld continue to buy

    assets at least until the unemployment

    rate has fallen below 7 percent

    "The Committee may choose to stop

    using this tool [QE] before the econom y

    has fully normalized."

    Even if we reach a s ituation this year

    where we dial back (stimulus ), we will

    still be running an accommodative

    policy.

    The housing market is very robust. The

    question is when do you get market

    forces to take that on. For me the

    answer is now.

    "It may be appropriate for the

    Comm ittee to buy additional assets

    even after the unem ployment rate falls

    below 7 percent."

    An exit is still way out in the future.I agree fully with the chairman that we

    should dial back on the stimulus.

    "The Committee shou ld keep its target

    range for the fed funds rate at its

    current extraordinarily low level at least

    until the unemployment rate has fallen

    below 5.5 percent"

    On Thursday, June 27, New York Fed President and FOMC Vice-Chairman Bill Dudley is scheduled to give a speech

    in which he may comment on monetary policy.

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    Investment

    Management

    DivisionThe FOMC Has Upgraded Their Outlook

    10Source: Investment Strategy Group, Datastream, Federal Reserve, GIR.

    1. FOMC & GIR Unemployment Rate Projections (As of June 25, 2013) 2. FOMC & GIR Core PCE Inflation Projections (As of June 25, 2013)

    The FOMC has revised its unemployment rate projections down since the end of 2012. In contrast, projections for

    core inflation have been also revised lower.

    The FOMC appears to have focused on changes in the labor market outlook more than on changes in the inflation

    outlook.

    7.6

    7.5

    6.9

    6.3

    7.6

    7.1

    6.3

    7.3

    6.7

    6.0

    5.0

    5.5

    6.0

    6.5

    7.0

    7.5

    8.0

    8.5

    9.0

    9.5

    10.0

    10 11 12 13 14 15

    Perce

    ntage

    Years

    Unemployment Rate June GS Projection

    Dec. 12 FOMC Projection June 13 FOMC Projection

    1.1

    1.81.8

    1.9

    1.81.8

    1.9

    1.3

    1.71.9

    0.0

    0.5

    1.0

    1.5

    2.0

    2.5

    3.0

    10 11 12 13 14 15

    YoY-

    Percent

    Years

    Core PCE Inflation (YoY) June GS Projection

    Dec. 12 FOMC Projection June 13 FOMC Projection

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    Investment

    Management

    DivisionSlight Shift in Communication Seems Inconsistent with Data

    11Source: Investment Strategy Group, Datastream

    1. US Real GDP Growth Through Q1 2013 2. Non-Farm Payroll Growth Through May 2013

    The economy has been growing at a moderate pace, and private demand had been resilient in spite of higher taxes

    and sequestration.

    Employment has continued to grow at a moderate but steady pace.

    Nonfarm payroll growth has averaged 155 thousand in the last 3 months as compared to 221 thousand in the prior

    5 months.

    7

    171

    -3

    -300

    -200

    -100

    0

    100

    200

    300

    400

    500

    600

    Jan-10 Jul-10 Jan-11 Jul-11 Jan-12 Jul-12 Jan-13

    Thousands

    Private ex Construction Construction Public sector

    155QE3: 135

    QE2: 49

    3.5%

    1.8%

    -14%

    -12%

    -10%

    -8%

    -6%

    -4%

    -2%

    0%

    2%

    4%

    6%

    8%

    06 07 08 09 10 11 12 13

    %QoQAnn.

    Years

    Real GDP Ex. Government Consumption and Investment Real GDP

    QE1

    QE2

    (3.3%) QE3

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    Investment

    Management

    Division

    99.0

    99.2

    99.4

    99.6

    99.8

    100.0

    100.2

    100.4

    100.6

    10 11 12 13

    USFinancialC

    onditionsIndex

    Financial Conditions Tighter

    QE2

    QE3

    US GDP Growth is Expected to Accelerate

    12

    1. GS GIR US Real GDP Growth Forecasts (QoQ Ann. %) As of June 25, 2013

    Source: Investment Strategy Group, Goldman Sachs Global Investment Research

    2. GS US Financial Conditions Index Through June 25, 2013

    2.4

    1.8

    2.0

    2.5

    3.0

    3.5 3.5 3.5

    0.0

    0.5

    1.0

    1.5

    2.0

    2.5

    3.0

    3.5

    4.0

    Q1 2013 Q2 2013 Q3 2013 Q4 2013 Q1 2014 Q2 2014 Q3 2014 Q4 2014

    QoQ

    Ann.%

    Forecast

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    Investment

    Management

    DivisionIs a Repeat of 1994 Likely?

    13

    1. Path of US 10-Year Treasury Yields

    Source: Investment Strategy Group, Datastream

    2. Drawdowns and Annual Returns Across Fixed Income and S&P 500 in 1994

    5.5%

    6.0%

    6.5%

    7.0%

    7.5%

    8.0%

    8.5%

    1.5%

    2.0%

    2.5%

    3.0%

    3.5%

    4.0%

    4.5%

    0 714

    21

    28

    35

    42

    49

    56

    63

    70

    77

    84

    91

    98

    105

    112

    119

    126

    133

    140

    147

    154

    161

    168

    175

    182

    189

    196

    203

    210

    217

    224

    5/1/13 Left Axis

    1/28/94 Right Axis

    Number of Days Since 10-Year Yield Trough

    The rise in interest rates since early May has drawn comparisons to1994:

    10-year Treasury yields have risen by a similar magnitude to the initial increase in 1994.

    This increase in rates has also been accompanied by declines in both bond and equity prices.

    -16%

    -10%

    -8%

    -7%

    -5%

    -12%

    -8%

    1%

    -3%

    -1%

    -13%

    -8%

    -6%

    -4%

    -5%

    -18%

    -16%

    -14%

    -12%

    -10%

    -8%

    -6%

    -4%

    -2%

    0%

    2%

    4%

    30-Year Treasury 10-Year Treasury S&P 500 Barclays USAggregate Index

    US Corp High Yield

    Drawdown During 1994

    Total Return in 1994

    Current Drawdown

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    Investment

    Management

    DivisionChina: A Confluence of Events

    15Source: Investment Strategy Group, Bloomberg, Datastream

    1. China: Real GDP Growth Bloomberg Consensus Expectations (%YoY) 2. China: 7-Day Shanghai Interbank Offered Rate (%)

    11.0

    7.2

    0%

    2%

    4%

    6%

    8%

    10%

    12%

    Jan-10 May-10 Sep-10 Jan-11 May-11 Sep-11 Jan-12 May-12 Sep-12 Jan-13 May-13

    7-DayS

    HIBOR

    Chinas growth expectations have fallen as new leadership has signaled a desire for quality growth at the

    expense of faster growth.

    Interbank rates spiked last week, with the overnight repo rate reaching an intraday high of >30%. This raised

    concerns about a banking crisis in response to central bank efforts to slow rising off balance sheet lending.

    The Peoples Bank of China has asked larger banks to play an active role in stabilizing the market. It also

    provided liquidity to some financial institutions this week.

    7.70

    7.65

    7.4%

    7.6%

    7.8%

    8.0%

    8.2%

    8.4%

    8.6%

    Jun-12 Aug-12 Oct-12 Dec-12 Feb-13 Apr-13 Jun-13

    ChinaConsensusRea

    lGDPGrowth(%YoY)

    2013 2014

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    Investment

    Management

    DivisionKey Takeaways

    16

    Clients should use the recent downdraft to build toward their strategic allocation to equities.

    While we think that interest rates will gradually rise over the next several years and lead to low

    Investment Grade Fixed Income returns, a repeat of 1994 is highly unlikely.

    We recommend tactically underweighting Investment Grade Fixed Income in favor of the following

    areas where the risk-return opportunities are much more attractive:

    High Yield Bonds

    US Bank loans

    Emerging Market Local Debt

    Euro Stoxx 50 (currency hedged)

    US Bank Equities

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    Investment

    Management

    DivisionImportant Information

    17

    Investment Strategy Group. The Investment Strategy Group (ISG) is focused on asset allocation strategy formation and market analysis for Private Wealth Management. Any information thatreferences ISG, including their model portfolios, represents the views of ISG, is not research and is not a product of Global Investment Research or Goldman Sachs Asset Management, L.P

    (GSAM). The views and opinions expressed may differ from those expressed by other groups of Goldman Sachs. If shown, ISG Model Portfolios are provided for illustrative purposes only. Your

    asset allocation, tactical tilts and portfolio performance may look significantly different based on your particular circumstances and risk tolerance. Your actual asset allocation, tactical tilts and

    portfolio performance may look significantly different based on your particular circumstances and risk tolerance. The model performance calculation assumes that (1) each asset class was owned

    in accordance with the recommended weight; (2) all tactical tilts were implemented at the time the recommendation was made; and (3) the portfolio was rebalanced every time a tactical tilt change

    was made and at the end of every quarter (unless a tactical tilt was made within a month of quarter-end). Performance is calculated using the daily returns (actual or interpolated) of indices that

    ISG believes are representative of the asset classes included in the model. Results shown reflect the total return but generally do not take into account any investment management fees,

    commissions or other transaction expenses, which would reduce returns. The results shown reflect the reinvestment of dividends and other earnings. All returns are pre-tax and are not adjusted

    for inflation. Additional information about the model portfolio performance calculation, including asset class benchmarks used for modeling performance and a history of tactical tilts, is available

    upon request.

    Forecasts. Economic and market forecasts presented herein reflect our judgment as of the date of this material and are subject to change without notice. These forecasts are estimated, based

    on assumptions, and are subject to significant revision and may change materially as economic and market conditions change. Goldman Sachs has no obligation to provide updates or changes tothese forecasts. Case studies and examples are for illustrative purposes only.

    Indices. Any references to indices, benchmarks or other measure of relative market performance over a specified period of time are provided for your information only.

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    sublicensed for use for certain purposes by The Goldman Sachs Group, Inc. The Dow Jones Industrial Average is a product of S&P Dow Jones Indices LLC and/or its affiliates, and has

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    are licensed for use for certain purposes by the Issuer. These securities, based on such index, have not been passed on by MSCI as to their legality or suitability, and are not issued,

    sponsored, endorsed, sold or promoted by MSCI, and MSCI bears no liability with respect to any such notes. No purchaser, seller or holder of the notes, or any other person or entity,

    should use or refer to any MSCI trade name, trademark or service mark to sponsor, endorse, market or promote the notes without first contacting MSCI to determine whether MSCIs

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  • 7/28/2019 The Federal Reserve Dont Let It Be Misunderstood

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    Investment

    Management

    Division

    2013 Goldman Sachs. All rights reserved.18

    Important Information

    18

    Indices. Any references to indices, benchmarks or other measure of relative market performance over a specified period of time are provided for your information only.

    Certain Investments / Strategies.

    Alternat ive Investments . Private investment funds and hedge funds are subject to less regulation than other types of pooled vehicles. Alternative investments may involve a substantial degree of

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    they respond to many unpredictable factors including weather, labor strikes, inflation, foreign exchange rates, etc. In an individual account, because your position is leveraged, a small move against

    your position may result in a large loss. Losses may be larger than your initial deposit. Investors should carefully consider the inherent risk of such an investment in light of their experience, objectives,

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