The minutes released yesterday from the Fed meeting on 18th September showed that the members who called for a rate cut, that is 7 of the 10 voters, pointed to weakness in global growth, trade uncertainty, weak manufacturing and business fixed investment. Also, the weakness in inflation was cited “as justifying a reduction of 25bp in the federal funds rate”. However, there was a push back in the minutes against a more aggressive cut
The US Treasury market rallied across the curve yesterday as geopolitical tensions intensified with the attack on the two oil tankers in the Gulf of Oman.
The short-end of the market is now pricing in three 25bp cuts to the funds rate this year and then nothing more, which is a little strange. Some argue for an ‘insurance cut’ as early as next week’s FOMC meeting sighting the Middle East situation…
Consider then the implications of short-term rates remaining at or below 3% for an extended period. In the usual recession scenario, the Fed raises its policy rate to the point where bank lending is either unprofitable or unwise. When that happens, banks invariably tighten lending standards, some of the less worthy borrowers struggle to obtain funding, and activity is constrained. To be clear, this ‘cleansing’ of debtors is a prerequisite for the next expansion; procrastination or life support, both of which waste valuable financial resources, simply delay the day of reckoning and make recessions longer and deeper.
Now consider then the implications of short-term rates remaining at or below 3% for an extended period, which is the Fed’s current outlook. Namely, the Fed expects short-term rate instruments, like commercial paper and overnight loans that are the main sources of funding for banks, to remain well below the current prime lending offered to commercial banks’ best customer – now 5-1/2%. Because the Federal Reserve has moved so gradually and predictably in raising short-term rates from very low levels, banks have been able to raise lending rates slowly as well, thereby maintaining ample margins on loans. In fact, loan margins have been at historic highs ever since the Fed lowered its policy rate to zero in the wake of the Global Financial Crisis. Banks tend to follow the Fed in adjusting lending rates to the cost of short-funding, albeit with some delay (i.e. banks mark up prices over costs), except at very low interest rates. This pricing behaviour implies that the Fed uses its policy rate in part as a tool for restoring banks’ balance sheets during times of stress as well as the converse - a means to cool off lending that threatens to overheat the economy.
That cyclical margin on loans is why an inverted yield curve is not necessarily a good predictor of recessions at very low interest rates. The Fed would have to raise the cost of borrowing above 5% to make loans unprofitable, and hence warrant tighter lending standards, whereas FOMC members now project the neutral policy rate at less than 3%. In short, an inversion of the yield curve enough to curtail lending does not seem likely anytime soon. Moreover, the Fed’s gradualism and predictability in recent years also has translated into a very gradual and manageable increase in borrowing costs. Indeed, the notion that Fed policy somehow has been destabilising or damaging to the real economy because interest rates have risen from very low levels is pure foolishness. Normalisation of the Fed’s balance sheet, on the other hand, has become problematic because it is on a collision course with the horrendous US budget deficit.
Western central banks face extraordinary challenges in unwinding their 10-year experiment with unconventional monetary policy that has left them with trillions of dollars of financial assets on their balance sheets and real policy rates still near zero. The Fed, as the first mover, will bear the brunt of these challenges for many reasons.
In a speech earlier this month, Federal Reserve Chairman Jerome Powell said he believed that inflation remained anchored and did not see any signs that it would spike despite the low unemployment rate, adding that he was not worried the Phillips curve ‘will soon exact revenge’. Talking at the National Association for Business Economics, Powell puts a strong emphasis on the anchored nature of inflation expectation in his thinking about the “dormancy” of the Phillips Curve.
The latest person to be caught in Donald Trump’s crosshairs (however, not for the first time) is the man he chose to be the chairman of the Federal Reserve, Mr Jerome H. Powell, who has disappointed the leader of the free world by raising interest rates. At a charity event for wealthy republicans, Trump told donors that he believes Powell should keep interest rates low, adhering to an easy-money monetary policy. Later, in an interview on Monday with the news service Reuters, Trump continued to show his displeasure. ‘I’m not thrilled with his (Powell) raising of interest rates, no. I’m not thrilled’
As expected the Fed left the fed funds target range unchanged at 1.75-2%. The decision was unanimous with a few wording changes to the statement reinforcing an improved growth outlook. There was no press conference post this meeting and the minutes are likely to be of more interest. The market is looking for another 25 basis point increase at the 25-26 September meeting.
Over the past week the term spread between 2-year and 10-year US Treasuries has averaged 25bps – equivalent to just one more Fed rate hike. Also earlier this week the 3-month Treasury bill yield touched 2% for the first time since 2008; this means that even short-term bonds now yield more than US stocks for the first time in a decade – becoming a viable alternative for those apprehensive about both stocks and bonds.
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.
Its Jerome Powell’s first policy meeting as Fed Chairman; and with the near certainty that rates will be raised to 1.5-1.75% everyone is really now only interested in what the man has to say about the effects of stimulus in an already tight labour market, inflation concerns, and any sign that the Fed is playing cautious in the early days of Powell at the helm. Currently implied probabilities show around 40% expect 3 quarter-point-rises this year with the remainder evenly split between expecting more or less than 3 hikes.
The major talking point today is Jerome Powell’s first testimony to the House Financial Services Committee as Fed Chair… (Unless you’re in London, then it’s probably the few inches of snow that we’ve not seen here in years. This so called “Russian snow storm” still isn’t the -20 degrees centigrade blizzard with record breaking snowfall that it was in Moscow.)
The longer end of the US curve is composed ahead of tonight’s release of Fed minutes: with 10-years yields, around 2.88%, back to where they ended last week, after the spike to 2.94% when January’s inflation data came in slightly above forecast. The shorter-end yields continue to rise, however: with 2-year yields touching 2.28% - almost double the yield they offered 12 months ago and moving further into 9.5 year highs (contrastingly over a 12 month period 30-years yields have risen 10bp from 3.04% to 3.14%).
As expected, the Fed raised the target range of the Federal Funds rate by 25 basis points to 1.25 - 1.5%. Interestingly, this time around both Charles Evans and Neel Kashkari dissented against the decision although neither will be ‘voters’ on the 2018 committee.
Also of interest from the market’s perspective was the updated set of economic forecasts. The median projection for the Fed funds rate is unchanged looking for three 25 basis point hikes in 2018 and two in 2019. Importantly, and in spite of some upward revisions to the committee’s growth forecasts and reduced slack in the labour market, the committee’s median forecast for core PCE inflation was left unchanged at 1.9% for 2018 and 2% in 2019. According to Janet Yellen, ‘most’ participants had factored in some fiscal stimulus and changes in financial conditions: the median forecast for 4Q/4Q 2018 GDP was revised up by 0.4% to 2.5% and 2019 was edged higher to 2.1% from 2%. The committee also revised its forecast for the unemployment rate to 3.9% from 4.1% for 2018 and 2019.
Next year there will a number of changes to the Fed voters: with the annual rotation of 4 of the regional Fed voting board members excluding the New York Fed President which is a permanent voter, although William Dudley is due to retire mid-2018. Plus, 3 potential seats (including Janet Yellen’s when her term expires in February and assuming Marvin Goodfriend’s nomination is approved) still to be appointed on the Board of 7 Governors.
We see the projected rate rise forecasts as on the aggressive side and would expect the pace of hikes to ease in the second half of 2018 as the previous hikes and balance sheet hikes start to take effect. We expect the Fed will remain ahead of the curve and the yield curve will flatten and we will continue to favour positioning at the long end.
Wall Street stocks rose, the dollar (DXY Index) touched a two week low earlier today and US Treasury 10-year yields shaved a couple of basis points following the release of the Federal Reserve’s September meeting minutes. These further confirmed expectations that interest rates could still be increased once more this year despite the notable dovish tone.
Although “staff continued to project that inflation would edge higher in the next couple of years and that it would reach the Committee’s longer-run objective in 2019”… “The risks to the projection for inflation were also seen as balanced.”
Today the US dollar seems to have halted the decline it had endured for the past few days. Treasury yields struggled to find their equilibrium yesterday, ending the day mostly flat, and are a touch lower today ahead of the forthcoming Fed meeting minutes. We should be able to see a little more detail on the discussions around unwinding the balance sheet and perhaps some important insights into the Fed’s view on the recent low core inflation figures. In any case, enjoy the finer points from what could be Yellen’s penultimate “full” Fed meeting (November and January meetings omit Economic Projections and Chair press conference).
Today the dollar continued its rally along with US equity indices whilst 10-year Treasury yields rose 5 basis points. The DXY Index is now up more than 1.4% so far this week; at 93.4 at time of writing, it is now back to where it was this time last month. Some of this may be due to profit taking from the recent rally in the euro (which is still up around 12% versus the US dollar year to date). The rest of the dollar rally and sell-off in Treasuries stems from hawkish comments from Fed Chair Yellen (and New York Fed President William Dudley) as well as market optimism over the anticipated tax proposal from President Trump later today.
As expected, the Fed left the Federal Funds rate unchanged at 1-1.25% and announced that it would begin the balance sheet normalisation program in October. The move to begin normalising the balance sheet was already outlined in June’s ‘Addendum to the Committee’s Policy Normalization Principles and Plans’. Between October and December the Fed will reduce its Treasury and Agency securities by USD6bn and USD4bn per month respectively and the caps will gradually rise over the next year to a maximum of USD30bn and USD20bn per month.
This Friday Prime Minister Theresa May will deliver a Brexit speech at the annual Pontignano Conference near Florence, Italy. It seems that Tuscany was the best platform for what will be May’s third update on Brexit plans (after the Lancaster House speech in January and the letter triggering Article 50 back in March), avoiding France and Germany where focus this weekend will instead be on the major labour reform demonstrations and federal elections respectively.
In recent congressional testimony, Chair Janet Yellen expressed dismay that inflation has remained persistently below the Fed’s target of 2% despite years of monetary stimulus and a decline in jobless claims to its lowest level in more than 40 years. This recent shortfall in US inflation seems strikingly ‘abnormal’ relative to that of recent years, especially in the context of a tighter domestic labor market and comes at an awkward time as the Fed has set course for an historic unwinding of its extraordinary policies of the past eight years. Will low inflation derail the Fed’s exit strategy? If not, where are they headed?
Yesterday we heard from Fed Chair Janet Yellen in what could be one of her last appearances before Congress. She acknowledged that the economy continues to grow (albeit slowly), jobs are being added and household consumption was up. However, Yellen believes that current Fed rate estimates would be lower ‘because the neutral rate is currently quite low by historical standards, the Federal Funds Rate would not have to rise all that much further to get a neutral policy stance’.