Turning Up the Heat on the Fed

Oct 24, 2018

The weakest E.U. composite Purchasing Managers Index in twenty-five  months is, in part, providing a bid in Treasuries to follow yesterday’s strong performance. The PMI weakness was across both manufacturing and services sectors and serves as another reminder that global growth may be stumbling.  And while yesterday’s Treasury strength owes a lot to the equity selloff, other issues are no doubt pulling at investors as well. One of those issues has to be the Fed and its seeming resolute nature to stay in hiking mode. The president weighed-in again last night in a WSJ interview noting that,  “Every time we do something great, he raises the interest rates.” The he refers to Fed Chairman Powell and the implication is to pause and pause now. The Fed, and Powell specifically, are unlikely to be cowed into pausing, and if anything it’s likely to steel their resolve to continue hiking, just to prove the Fed’s independence, There’s probably a bit of that thinking too in this morning’s Treasury strength. The 10-year note is up 9/32nds in price to yield 3.13% with 3.11% the next line of resistance. 

 

  Economic News

 

The release of the FOMC minutes last Wednesday were taken to be rather hawkish with a clear consensus that rate hikes will continue into restrictive territory, not just to the mystical neutral level. That revelation didn’t surprise us as some of the Fed Speak following the meeting had been pretty direct that the so-called neutral rate (estimated between 2.50% and 3.00%) would not necessarily represent a pausing point. The commentary was mostly along the lines that given the strength in the economy, and a declining unemployment rate, tightening the fed funds rate into restrictive territory may be necessary to offset possible inflationary  forces.

 

While the post-meeting commentary and subsequent confirmation in the minutes surprised some as excessively hawkish, if one looked at the Fed’s Summary of Economic Projections (SEP), the post-meeting Fed Speak, and minutes it would have seemed to make more sense. In the September SEP the forecast called for inflation (Core PCE) to run at 2.0% this year and rise only to 2.1% over the next two years. Fed officials obviously feel quite confident they can keep inflation more or less at their 2.0% target. 

 

Meanwhile, curiously they left the longer-run unemployment rate forecast at 4.5% while calling for unemployment to bottom at 3.5% over the next two years before rising to 3.7% in 2021. The longer run number is the Fed’s current call on the non-accelerating inflation rate of unemployment (NAIRU). That is, the unemployment rate that represents a balanced, full- employment labor force that is neither running “hot” nor carrying excessive labor force slack.  It’s curious in that the 4.5% rate has been unchanged for over a year and a half despite the unemployment rate dipping well below 4.0% with only modest wage inflation. Thus, the Fed must feel strongly that the 4.5% rate is consistent with a non-inflationary, full-employment labor market. 

 

When one looks at the inflation and unemployment forecast it would seem in conflict to think the Fed would pause rate hikes with the unemployment rate nearly 100 basis points below the longer-run rate while also forecasting a docile inflation trend. Instead, it’s more reasonable to assume they will continue to hike as long as the unemployment rate remains under their longer-run expectation in order to prevent the labor market from overheating leading to outsized wage gains and demand-pull inflation that could imperil the 2%/2.1% inflation call. Indeed, the Fed’s forecast seems to imply they will continue to hike and slow employment growth until the unemployment rate starts to head back towards the 4.5% NAIRU level.   

 

That implication is also consistent with their GDP forecast from the September SEP in which they call for GDP to peak at 3.1% this year before dipping to 2.5% next year and 2.0% in 2020 before dropping further to the longer-run rate of 1.8%. That long-run rate coincides with the current productivity level and population growth of the U.S. economy which dictates the longer-run capacity for GDP growth. 

 

The confluence of those forecasts and post-meeting statements mesh rather well with the minutes and the implication that the Fed is serious about keeping inflation at bay, and that an unemployment rate below 4.5% is essentially running the labor market “hot” which necessitates moving the policy rate into restrictive territory thereby slowing the economy and cooling off the labor market.  

 

Part of the equity volatility we’ve seen of late can be traced to the realization that the Fed is serious about moving the fed funds rate into restrictive territory, intent on realizing the long-run objective of 1.8% GDP and 4.5% unemployment all in the quest to keep inflation near 2%. While earnings results this quarter have been strong, the thought that with a hawkish Fed looking to keep inflation from gathering any momentum, peak earnings may be a real possibility in the near-term. We’ve mentioned often in recent weeks that the rate hikes in 2019 will be tougher to engineer as the funds rate moves into the neutral range (2.5%-3.00%), and beyond, but for right now, the Fed is singing a pretty consistent song that rate hikes will continue past the neutral range and that has long-term bonds resistant to higher yields as the slower growth and quiescent inflation forecasts seem to be reasonable given all we know and see from this Fed.

 

 

 

Market Update  Financial Conditions Index Tightens to 17-Month High

 

While the Fed talks-up the economy and projects rate hikes well into restrictive territory, financial conditions are already tightening to levels last seen 17-months ago. The graph shows the Goldman-Sachs Financial Conditions Index reaching a high last touched in May 2017. The October stock selloff and volatility has had a lot to do with the recent increase but the index has been tightening since January. Perhaps its reacting too to the performance in bank stocks that have been in a funk for most of this year as things like higher deposit betas and margin compression, not to mention the occasional credit issue (see Bank of the Ozarks), conspire to keep them under pressure. If conditions continue to tighten that could be an obstacle to the Fed’s rate hiking plans.

 

Financial Conditions Index Tightens to 17 Month High

 

 

Agency Indications Agency Indications — FNMA / FHLMC Callable Rates

 

Agency Indications — FNMA / FHLMC Callable Rates

 

 

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