The latest curveball in the US/China trade talks has thrown markets for a loop, and the risk-off trade in stocks has provided a bid in Treasuries with this morning’s rally putting the 3mo-10yr spread just one basis point from being flat (3mo 2.42% vs. 10yr 2.43%). While the 2yr-10yr spread gets all the press, the former has a better track record of predicting Fed eases when it inverts so we’ve no doubt the latest flattening move has the Fed’s undivided attention. While the current move has its genesis in the trade rhetoric if we get to the weekend with no deal and increased tariffs become a reality, expect the negative shock to global economies and concomitant flight-to-safety trade to invert the 3mo-10yr curve. That will certainly alter the Fed’s patient pause calculus as an ease would seem to be in order to counteract the inversion move. To be sure that’s not our baseline forecast. While we admit no expertise in foreign trade negotiations, the latest move to threaten increased tariffs seems a negotiating tactic to us. The president is keenly aware of every twist and turn of the stock market and pushing tariffs on practically every Chinese import, when a trade deal was expected and priced in last week, could lead to a lasting stock market correction. We don’t think he wants to go there, and stocks are indicated lower this morning in a continuation of yesterday’s trade-related selling. With the China trade delegation heading to DC for face-to-face talks tomorrow and Friday, after initial reports had them cancelling, it does lend some credence that the tariff talk is a negotiating tactic. In any event, if we get to the weekend with no deal, or extension, the Fed may have to rethink its patient pause stance.
While the trade kerfuffle will play out over the next few days it has distracted investors from the most important release this week which is Friday’s April CPI numbers. With the labor market notching consistent job gains, and modest to moderate wage gains, it hasn’t altered the Fed’s patient pause posture that it struck in January. Even after last Friday’s solid April jobs report Treasuries rallied as the slight miss on wage gains was thought will keep the Fed on hold for the foreseeable future.
That reaction came because the market perceives the key ingredient to moving the Fed off its patient pause position is whether inflation trends towards 2%, or continues to leak lower. All other considerations, whether it is job growth and/or economic growth, take a back seat right now to inflation as a guide to future Fed rate decisions (with the exception of a trade-related one-off entering the equation). With wage gains slightly missing expectations at 3.2% YoY versus the 3.3% forecast, markets perceive that while labor markets continue to post strong job gains, wages haven’t experienced material acceleration, much to the surprise of the Phillips curve proponents on the Fed. That will keep one source of long-run inflation at bay, and that is a big reason markets see the Fed’s next move as a cut and not an increase. The downward trend in inflation, however, may have run its course with an uptick expected in the April numbers.
For the month, overall CPI rate is expected to increase a healthy 0.4% which would match the March gain due to continued oil and gas price increases. The year-over-year overall rate is expected to increase 2.1% versus 1.9% in March. That rate bottomed at 1.5% YoY in February when oil prices were bottoming as well. The more important core rate (less food and energy) is expected up 0.2% in April versus 0.1% in March. The year-over-year rate is expected to edge up to 2.1% from 2.0% in March. Recall the Fed’s preferred inflation measure, core PCE, tends to run about 30bps behind core CPI so with that rate expected to edge up to 2.1%, core PCE is likely to print around 1.8% from its current 1.6% rate. The April PCE report is due on May 31st.
Despite a modest increase in inflation, we continue to think the Fed remains patient throughout this year as they assess the impact of the nine rate hikes on the economy. Recall the last hike was in December so given the lagged impact of hikes on the economy, the Fed is right to maintain a patient posture. The question becomes if core CPI, and hence core PCE, continue to edge higher to 2%, or above, will the Fed maintain that patient posture, or will they get itchy rate-hiking fingers?
While most Fed members have tried to talk a good game that the 2% target is a symmetric one— meaning the rate could spend just as much time above 2% as it has below— the proof will be in the pudding, as they say. With constant reference that below 2% target inflation is caused by “transitory” factors will they use that same term if inflation trends above 2%? We think if wage gains remain above 3% YoY and core inflation trends over 2% the Phillips curve adherents will get anxious that the long-anticipated demand-pull inflation is here and they will want to hike rates in order to nip that inflationary impulse in the bud before it accelerates.
Ultimately, we see the Fed on pause throughout the balance of this year, unless the US/China trade dust-up spirals into a tit-for-tat tariff war then a palliative easing would seem appropriate. Absent the trade deal falling apart, we put greater odds that economic growth and wage gains continue with inflation trending towards the 2% target. That will put the Fed’s lofty talk about the target being a symmetric goal to the test. If it’s true, and inflation remains within arms-reach of the target, the funds rate should remain at its current level. We’re not convinced, however, that the Fed will remain patient if the rate moves over 2%. Old habits die hard and all that.
Core PCE’s Downward Trend Appears About to End
If expectations for April CPI are any indication, the downward trend in core PCE—the Fed’s preferred inflation gauge—appears poised to end, but only grudgingly. April CPI numbers, which are due on Friday, are expected to show month-over-month and year-over-year increases such that core PCE is likely to post a 1.8% year-over-year increase versus the 1.6% posted in March. While that increase will still be short of the 2% target, the downward trend started in mid-2018 looks like it will be reversing as persistent oil price gains in 2019 continue to bite and the pause in rate hikes allows other prices to lift.
Agency Indications — FNMA / FHLMC Callable Rates
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