Treasury yields are once again moving lower with the 10-year testing 3.00% and curve flattening challenging cycle-low levels of August as a possibly more flexible Fed meets with some softer economic results. Yesterday, the FOMC minutes from the November 7-8 meeting were released and they confirmed what Fed Chair Powell and Vice Chair Clarida covered in their speeches this week. That is the rate path after December will be more flexible and based on incoming data that informs as to the rate of growth in GDP, employment and inflation. Speaking of growth, we received two housing reports this week that reinforce the slowing theme in that sector. Pending Home Sales were off –2.6%MoM versus 0.5% expected and New Home Sales were off 8.9%MoM versus 4.0% expected. The softness in housing and autos highlights Powell’s comment that rate hikes take a year or so to manifest in the economy. Looks like we’re seeing that in the interest-rate sectors. Meanwhile, the big event yet to happen is the G20 meeting this weekend in Buenos Aires and the Trump/Xi dinner date with discussions of US/China trade being the main course. While we expect some positive-spin headlines that may temporarily boost stocks and pressure bonds, we don’t expect a substantive breakthrough, especially with trade hardliner Peter Navarro in the American contingent.
|Economic News||Fed Funds Rate Approaching Lower Range of Neutral||Market Rates|
There’s been a plethora of Fed news this week that has markets repricing rate hiking expectations for next year. First we were greeted with Fed Vice Chair Richard Clarida’s speech in which he laid down the marker that rate changes will be guided by the data. In essence, as long as GDP and employment growth remain above long-term trends gradual policy normalization would be the order of the day lest the inflation genie be loosed from her bottle. He also ventured into the neutral rate versus current fed funds rate territory saying we are close to the lower range of neutral (that being something around 2.50%-3.50% but with models clustering around 3.00%).
Clarida’s scholarly speech was followed by the more practical comments from Fed Chair Jay Powell on Wednesday. The big market takeaway from that speech was his comment echoing Clarida’s view that “rates are near the bottom edge of the range of neutral estimates.” That view softened his early October comment that policy rates were a “long way” from neutral and that set equity markets on fire and fed funds futures pricing out all but one hike in 2019.
It seems clear that the aligning of Clarida and Powell’s perception that policy rates are near the lower edge of neutral estimates represents an attempt to walk back some of the “we may have to raise above neutral” talk by some Fed members that no doubt encouraged, if not led to, some of the October equity selling. The weakening in housing and auto sales (not to mention the GM plant-shutting news) probably helps make the case that rates are indeed closer to neutral than previously thought.
Powell’s speech also served to unveil the Fed’s first Framework for Monitoring Financial Stability. In that work he noted that asset price levels, including equity valuations, are one of the four potential vulnerabilities to financial stability. That’s a clear admission that the Fed does indeed watch equity markets as another input in their policy decisions. To quote from his speech, “Large, sustained declines in equity prices can put downward pressure on spending and confidence.” The equity selling in October no doubt got their attention, and preventing a “sustained decline” probably had something to do with the change in characterization of how close policy was to neutral.
As to what this means for rate hikes, and rates in general over the next year, it’s our view from the pair of speeches and the minutes that the Fed, while claiming to be data-dependent for years, will REALLY be data-dependent going forward. The easy hikes, after December, are done. When the funds rate was so far from any estimate of neutral and GDP and employment growth were running above long-term potential the rate hiking decisions were rather easy.
With the acknowledgment that policy rates are approaching the lower end of the neutral range, policy decisions next year will be driven by inflation, growth and employment trends. Thus, we could see one hike next year (like the market is calling for) or it could be four in keeping with the previous quarterly cadence if growth surprises to the upside. We think the actual number of hikes will be at the lower- end, possibly two, as GDP growth slows to the mid-2% range along, with a simultaneous slowing in employment gains, with inflation remaining well-behaved.
While a rate hike at the December 19th FOMC meeting is a fait accompli, the real juicy tidbits will be found in the updated economic and rate forecasts (Summary of Economic Projections). If the dot plots project a slower and/or lower rate hiking path expect yields to fall on the downgraded hiking scenario. However, if they stick to the September path with rates peaking at 3.50% in 2020 and 2021 before settling at 3.00% expect the rallies of this week to reversed to some extent but we don’t foresee the 10-year retesting 3.25% anytime soon.
In the end, no matter the changes to the December forecasts, policy will be guided more than ever by the data. In addition, with the G20 meetings this weekend, it points to the fact there will be plenty of exogenous events that will interact with the hard data. The changing of control of the U.S. House in January, the Mueller investigation findings, and Brexit in March are but three of the events that will have ramifications on the economy and policy rates.
Fed Funds Rate Approaching Lower Range of Neutral
While the market took Fed Chair Powell’s comment that the fed funds rate is approaching the lower range of neutral rate estimates as a sign that a pause may be near, others are saying that there is still plenty of room to hike if the upper range (3.5%) is considered. Without getting lost in the weeds of a range, the more important point of Powell’s comment is that after December’s expected hike, approaching the neutral range will place much more emphasis on the incoming data to make or break the case for a hike or a pause. Speaking of which, the fact interest rate-sensitive sectors like housing and autos are softening will begin to weigh on the Fed’s decision-making.