Jackson Hole and Other Great Fly-Fishing Spots

Aug 24, 2018

Markets are mostly quiet this morning as investors await Jay Powell’s keynote address to global central bankers gathered at Jackson Hole, Wyoming. He’s scheduled to speak at 10am EDT. We go into further detail below on our expectations for the speech but the weight of it is centered on how engrained the 25bps per quarter rate hiking schedule is given the somewhat  dovish take of the August FOMC minutes, the approach of fed funds to the mystical neutral rate, and the political and emerging market fallout subsequent to the meeting. Treasuries will tell us if the speech is interpreted as calling for a pause sooner than the rate hiking schedule as laid out in the June forecast. If that is the case expect the 5-year area of the curve to rally. That’s because the market has never believed in the Fed’s forecasted terminal rate of 3.5%. If the Fed finally starts showing signs they don’t believe it either the belly should rally. On the other hand, a speech that remains steadfast in the quarterly hiking schedule, and the 3.5% terminal rate should pressure the belly but probably rally the long-end as the market interprets a Fed likely to tighten too much.


  Economic News


The gathering of global central bankers in Jackson Hole kicks off this morning with Fed Chair Jerome set to give the keynote address “Monetary Policy in a Changing Economy” at 10am EDT. While the speech’s details haven’t been released Powell will probably touch on the productivity conundrum, the flattened Phillips Curve and the lowered Neutral Rate and the impact they will have on monetary policy if their present levels remain in place for the long-term. Hints on the pace and number of future rate hikes will be gladly accepted as well.


In fact, with the release of the Fed minutes from the August 1st meeting we’re starting to get a better view of the Fed’s adjusted reaction function to future rate hikes, and they may be getting closer to a pause than they would like to let on.  The four issues found most pressing to the Fed in the minutes were:   1) trade tensions and the domestic economic fallout, 2) emerging markets, 3) housing sector and 4) fiscal stimulus fading, or austerity returning following mid-term elections. It should be noted too that the meeting took place before the recent leg down in the Turkey crisis, further Chinese yuan declines, additional tariffs, and the heightened political uncertainty.


Thus, the list of concerns has only risen in intensity since the meeting, and when you  add in the “for now” qualifier that Fed Chair Powell gave in his recent congressional testimony as it pertains to quarterly rate hikes, the case for a pause could be starting to ferment in the halls of the Marriner S. Eccles Building. The other items that would argue for a pause sooner rather than later are the yield curve nearing inversion and the approach to the mystical land of the neutral rate.


The 2yr-10yr Treasury spread set a new cycle low of 20bps yesterday and the neutral rate (the rate that is neither too tight or too loose), is within sight. The minutes discussed the shape of the yield curve and the potential recessionary signal an inverted curve sends, and while no consensus was reached it’s clear that hiking close into an inverted curve will invite some dissent. Also, some Fed models have the neutral rate near 2.50%, thus, two more hikes would put us there.


While a September rate hike is a fait accompli a December hike remains a slightly better than 60% proposition in the market’s eyes.  Getting a hike in December and thus reaching some estimations of the neutral rate would seem a reasonable point to pause. While we’re not likely to get such a clear call from the Fed Chair in today’s speech we should get some clues.


The challenge for the Fed in moving to a pause is the communication around the reason and thereby giving investors an opportunity to gauge the length of the delay. A pause, if it comes in December, or just after, will likely induce a rally in the belly of the curve rather than the short-end. The 2-year has been rather dogmatic in pricing in two additional hikes to the current level while the belly has risen it’s never really believed the 3.5% terminal rate forecast. Thus, if that terminal rate forecast of 3.0.% to 3.5% starts to look dicey to the Fed, the five-year sector is likely to rally in response.


The housing sector was another item the Fed noted in the minutes as a possible cause for concern and the news since the meeting is likely to make their concerns well-placed. New home sales for July printed below expectations at -1.7% month-over-month versus +2.2% consensus, with modest upward revisions to June. That makes it three-for-three in lackluster housing releases this week as the FHFA House Price Index also came in below expectations (albeit with slight upward revisions to the prior month), and existing home sales declined month-over-month for the third straight month.


To be fair, the misses  aren’t major, and the level of activity is still decent, but the preponderance of evidence is starting to show a plateau of sorts in the housing market. Weekly mortgage application activity has also weakened with purchase applications declining in five of the last six weeks. With applications a leading indicator of future closing activity the weakness there doesn’t bode well for a near-term reversal. Also, the peak buying season is now behind us and while July typically declines MoM, this year’s was steeper than average.  As such residential investment will subtract from third quarter GDP and the prevalence of softer-than-expected data will highlight concerns about the impact of higher rates on the US housing market. 30-year mortgage rates are up 70bps in the last year while 15-year rates are up 85 bps.



Market Update  Fed Model Shows Fed Funds Near Neutral


One topic that has been getting more attention by the Fed and by market analysts is the fed funds rate approaching neutral. One Fed model (Laubach-Williams) estimates the neutral rate (the level that is neither easy or contractionary), at 2.096%. Whether that level is accurate is a matter of debate but other estimates are nearby meaning a hike in September and another possible hike in December will certainly put the funds rate near, if not above, the neutral rate. We’ll also be eight to nine hikes in which is the average number of hikes  in recent tightening  cycles. Thus, it would seem a another hike or two would be a reasonable point to pause and assess the impact of hikes to date.


Fed Model Shows Fed Funds Near Neutral



Agency Indications  Market Rates


Market Rates



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