The Daily Update - Fed Up to Your Eyeballs

Along with the Beige Book release yesterday we have had a queue of Fed Presidents/Board Members giving 1, 2 or 3 speeches this week including: Atlanta’s Raphael Bostic, Chicago’s Charles Evans, Philadelphia’s Patrick Harker, New York’s William Dudley, San Francisco’s John Williams, as well as Vice Chairman Randal Quarles speaking and giving testimony to the Senate Banking Committee. Moreover, later today, Board Member Lael Brainard addresses regulatory reform, Cleveland’s Loretta Mester delivers her economic outlook and Quarles continues his testimony… with Evans wrapping up his outlook and the week. And all this whilst long-short term Treasury spreads (take your pick: 2/10-year, 2/30s, 5/30s, 10/30s …) reach their narrowest since 2007.

(Seeing as reading the schedule is arduous enough) Here are some highlights and expectations from all this week’s data and discussion (myriad across the Districts).

The Beige Book gave a balanced outlook, caveating “a modest to moderate pace” (in Mar/Apr) with no less than three-dozen references to “tariff(s)” across Districts and sectors. Consumer spending and manufacturing activity were broadly up with notable drags from “persistent drought conditions” and steel/aluminium prices. Notable for their absence was the lack of references to Trump’s recent tax cuts. Perhaps tariff concerns quashed the enthusiasm and activity that tax cuts promised; perhaps it suggests businesses saw the cuts more as an income cushion, than as an opportunity to expand in the near-term (as US deficits climb to 6%). Tariffs were one of the main concerns for outgoing New York Fed Chief Dudley who indicated that trade and the federal budget were significant challenges.

Elsewhere across the Fed Districts: Bostic held firm to the middle ground – with little concern over inflation or for holding-off raising rates – advocating for the Fed to develop a “more neutral stance”. Evans expressed more of a dovish sentiment that "we have the opportunity to more patiently read, and react to, the incoming data", recalling the rapid raising of rates in the ‘70s that induced a recession. Harker was polemic on the wider ramifications of “the looming shadow of student debt” for the US economy and its younger generations. Quarles testimony, pitching the easing of post-financial crisis regulations, will conclude on Friday but is already receiving pushback from Democrats, amongst others.

Meanwhile in Madrid, Williams spoke of his expectations for inflation to stay around or above the (symmetric) target of 2% for a “couple of years” but is not worried as “there are global factors that are holding inflation down”. Previously more dovish, he now expects hikes to put the policy rate between 3.1%-3.6% by 2020 with longer rates moving up somewhat in tandem - necessary to avoid an inverted yield curve.

The problem is that since the Fed began raising rates in December 2015 yields for short dated Treasuries, from 1-month to 2-years, have risen between 151bps and 168bps in line with the 150bps of hikes so far. 30-year Treasury yields however have moved up just 18bps during this period. In fact, this trend of narrowing term-spreads goes back further. Since 2013 there looks to be a bound trajectory of the 2/10-year Treasury spread – which if it continues forecasts an inverted yield curve by end-2019 (the recent 18-month path suggest a potential inversion before the end of this year).

With the 2/10-year spread now at 46bps the market reaction to the next hike should be telling. If this hike finally succeeds where the past 6 hikes have failed, namely to correspondingly raise longer term rates, then the current path and market expectations may indeed be played out slowly but surely. The interesting scenario, however, is if longer term paper remains stubbornly hard to force up. Then we could see a term-spread no larger than a rate hike increment itself, and the Fed could have the difficult decision whether to hike one last time at the risk of directly inverting the yield curve by their actions… which would be a sight to be seen (that is, if it didn’t bring on a recession).

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