Fed Chair Jerome Powell’s testimony yesterday to the Senate Banking Committee was mostly unsurprising and that helped boost the dollar as the quarterly rate hike scenario still seems in place despite trade-related anxieties (more on that below). His “for now” qualifier garnered some attention and tempered dollar gains but it seems a prudent caveat given the geopolitical noise at the moment. The testimony also helped the curve flattening trend with the 2yr-10yr spread dipping to a new cycle low of 24bps yesterday. He’ll reprise his testimony to the more partisan and less insightful House Financial Services Committee today. Finally, housing starts for June were just released and missed badly with a month-over-month drop of -12.3% when a –2.2% dip was expected. Permits missed too but by a smaller amount (–2.2% versus +2.2% expected). They were down, however, for a third consecutive month. By the way, weekly mortgage applications were down -2.5% and -12.1% YoY. Is the tightening trend and higher rates finally biting into housing demand? The mix of soft housing news has Treasuries finding a modest early bid with the 10-year up 3/32nds to yield 2.85%.
|Economic News||2yr-10yr Spread Continues to Flatten||Agency Indications|
Fed Chair Jerome Powell kicked off two days of Capitol Hill testimony with remarks before the Senate Banking Committee that offered little fresh insight but that was what was expected: no surprises. The economy is doing well, the inflation target is symmetric, and for now the best approach is to continue with gradual rate hikes with a “for now” qualifier. That caveat seemed only prudent given the geopolitical and trade concerns at the moment but it still garnered some attention.
The bigger question for investors is when will the Fed move from quarterly hikes that for now seem set on autopilot to more nuanced and delicate policy action? In the round of questioning, Powell did reveal that that point will be reached when we get the fed funds rate closer to the so-called neutral policy rate. Again not a surprising admission but an admission nonetheless.
In the Fed’s world, they have kept policy on the easy side of neutral more often than not. Comparing the real fed funds rate with the Laubach-Williams estimate of the natural interest rate (the rate that is neither accommodative nor restraining) shows that restrictive policy stances since the turn of the century are the exception rather than the norm. Fed hawks will argue the rise in inflation over the last year has mostly offset the rate hikes such that the accommodative monetary policy in place since the Great Recession hasn’t really been tightened that dramatically. Perhaps that’s one reason why economic growth has been so resilient, though accommodative fiscal policy in the form of tax cuts has also helped keep the economic engine running smoothly.
The problem with guiding policy towards the neutral rate is that no one knows exactly where that rate is. It’s what’s called an unobservable variable. One can estimate it’s location but it’s still, at best, an estimate. Think of it like moving around a darkened bedroom in bare feet. You know the approximate location of the bed and other possible collision points, but you’re not exactly sure, so you find yourself groping along carefully and slowly in the dark lest you painfully stub a toe.
Given this uncertainty, it seems likely the Fed will become more cautious once it views itself as approaching neutral. The Fed’s Laubach-Williams model suggests another 50 bps will do it, though other estimates of neutral might offer a bit more wiggle room, allowing perhaps a third hike. This is one reason why markets are reluctant to fully price the dot plot projections in 2019-20. The market expects the Fed will become more data-sensitive, more cautious once they hit neutral, and that, given the modeling, puts the fed funds rate somewhere between 2.5% and 3%.
Powell himself noted in the Q&A that he prefers to focus on the neutral interest rate, and that long rates are an approximate estimation of that level. With 10– and 30-year bonds between 2.85% and 2.96%, it’s another indicator of where the neutral rate lies.
The question becomes once that neutral rate is struck, how long does the Fed stand pat? The fed funds futures market prices the neutral rate being hit in late 2019 and then stabilizing at that level for as far as the eye can see. It seems to us, however, with rates moving up another 100bps or so, the expansion entering its tenth year, and the sugar high of tax cuts having passed through the system that a slowing economy needing an easing cycle to avert a recession may be more likely. Thus, we expect the terminal level to be more a short-lived event with an easing cycle following in short order.
That timeline puts an easing cycle as early as 2020, and thus booking yields before they fall may be a 2019 affair and closer than some may suspect as we sit on the eve of what is likely a near 4% GDP print in the second quarter. While that outsized print will be impressive, it’s just as likely to be a one-time event with prints returning to the 2% range in short order. As we mentioned, the sugar rush of tax cuts will be gone in 2020, and the BLS just released it’s second quarter median wage report with incomes rising 2.0% in the twelve months ended June but that compares to a 2.7% annual gain in CPI. Thus, median wages fell in real terms over the past year and with an economy two-thirds dependent on consumer spending one can only wonder how long the 3%-4%levels in consumer spending can continue?
2yr-10yr Spread Continues to Flatten
Some Fed officials have expressed concern about “forcing” the yield curve into inversion (i.e., higher short-term rates vs. lower long-term rates) because of the recessionary implications of an inverted curve. Combine that concern with Fed Chair Powell’s Senate testimony yesterday that a neutral policy rate is best approximated by long-end rates. With a 24bps 2yr-10yr spread, that implies another two hikes could be enough to invert the curve, something the Fed seems likely to avoid. It also places the rate near the neutral point. That would imply a pause, perhaps late this year or early 2019 with an easing cycle awaiting nothing but a softening in the economy.
Agency Indications — FNMA / FHLMC Callable Rates