The main event of the week arrives today with the first of two days of congressional testimony from Fed Chair Jerome Powell. At 10am ET this morning Powell appears before the House Financial Services Committee and tomorrow he will reprise his appearance before the Senate Banking Committee. The testimony is part of the Fed chair’s semi-annual obligation to inform Congress of the Fed’s activities as Congress fulfills its oversight responsibilities. While we are sure to be distracted, and perhaps entertained, by grandstanding, pontificating legislators trying to grab a sound-bite for their constituents back home the market will be looking for any sign that Powell is not comfortable with the market’s expectation of a 25bps rate cut at the July 31 FOMC meeting. Powell and senior leadership at the Fed have had several instances over the last few weeks to push back on the market’s rate-cutting expectations and while the solid June jobs report effectively removed odds of a 50bps rate cut, a lesser 25bps cut for July 31 is still sitting at 100% odds in the fed funds futures market. Thus, the market will be focused on comments that reflect either comfort or consternation with the market’s rate-cutting expectations.
While investors will be fixated for the next two days on Powell’s comments on Capitol Hill, the thinking here is that he won’t reveal his cards in full, but there will also not be a forceful pushback to the market’s expectation of a 25bps rate cut. While the strong jobs number dimmed odds of a more forceful cut (i.e., 50bps) and expectations of 75bps in cuts this year have been dialed back to 50bps, reasons still exist to think a rate cut is the likely next move in the rate policy path.
First, while headline job growth easily beat expectations, wage growth missed forecasts and the year-over-year gains have dipped some from a 3.4% cycle high set back in February. The June YoY gain was 3.1% for the second consecutive month and the inability to climb back towards 3.4% implies wage gains are plateauing around 3.0%-3.1% despite the ongoing job growth and unemployment well below 4.0%. Thus, the expected acceleration in wage gains as job growth continues is just not occurring to the degree that Phillips Curve (lower unemployment begets greater wage inflation) disciples would have expected. With wage gains remaining modest that gives the Fed freedom to consider easing as wage-led inflation doesn’t seem to be an issue.
Second, the CPI release due tomorrow is expected to continue with modest inflation numbers (1.6% CPI and 2.0% Core CPI). If that report matches expectations, or is weaker-than-expected, it provides another green light for the Fed to move forward with a July rate cut. Even if the report exceeds expectations, the sources of that beat have to analyzed, and given the aforementioned moderating wage gains, it wouldn’t foreclose a rate cut. In addition, the Fed’s preferred inflation measure, core PCE, remains under 2% at 1.6%. The trend for PCE is to run about 30bps below CPI so with core CPI expected at 2.0% that implies core PCE increasing slightly to 1.7% but still below the 2.0% target. Thus, inflation levels shouldn’t inhibit a July rate cut.
Finally, the June FOMC statement mentioned increasing global “uncertainties” and while some of that uncertainty may have been reduced with the G-20 announcement that the U.S./China trade talks were resuming, reports have surfaced that contentious issues are already slowing even the resumption of talks. That illustrates that “uncertainties” will continue, and with the global slowdown increasing, the Fed has the conditions to take back the much-criticized December rate hike later this month and then see what how the data unfolds into September and then into year-end.
Recall too the latest second quarter GDP estimates are calling for a 1.3% growth rate (Atlanta Fed GDPNow) and 1.8% (Bloomberg Consensus). If the Atlanta Fed’s estimate is closer to what is reported on July 26, a mere five days before the Fed decision, it could provide another rationale for an insurance cut. So, if a rate cut is forthcoming at the end of the this month expect the short-end to remain at current levels while investors assess and price in the probability of another cut either in September or December. With the 2-year note currently at 1.88%, it looks like two 25bps cuts are contemplated.
The 10-year note is currently yielding 2.06% after flirting with 1-handle yields prior to the jobs report. That’s an important point to make. If a strong jobs report is only good for a 10bps yield pullback what else could push it higher from here? Stronger growth? We’re already looking at GDP that seems likely to struggle staying around 2.0%. Higher inflation? We’ve already mentioned the modest expectations for CPI, and with wage gains plateauing is there sufficient fuel to generate demand-pull inflation? That seems a stretch. Weaker dollar? While there was some weakening of the dollar after the June FOMC meeting, and the certainty that rate cuts were coming, the dollar has since rebounded given overseas weakness and that will keep imports and commodities cheap, and exports expensive.
That is not a recipe for higher yields. In fact, the global slowdown story and the associated “uncertainties” have not receded since the June meeting, and, if anything, have intensified. So, it looks like any pull back in 10-year yields is more than likely to be shallow with 2.25% strong near-term support. Meanwhile, if signs indicating further weakness increase from global and/or domestic sources it will put 1-handle yields back in play.
Trade-Weighted Dollar Index Rebounds
One of the headwinds to inflation has been the ongoing strength in the dollar. As the graph shows, for most of the last year the dollar strengthened against a trade-weighted basket of foreign currencies as four rate hikes compared to overseas economies that were showing signs of slowing and stress. The dollar strength took a hit after the June FOMC meeting when rate cuts looked to be the new policy path. The June drop has ended, however, as the jobs report dimmed odds of more aggressive rate cuts and further signs of slowing in overseas economies and uncertain trade developments weigh on sentiment. As dollar strength persists it will continue to limit any inflationary forces from trade.
Agency Indications — FNMA / FHLMC Callable Rates
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