With the U.S. withdrawal from the Iran Nuclear Agreement, geopolitical risk has moved front and center. That risk, however, provides an undercurrent to the markets Meanwhile at the surface, investors get more tangible, real-time information in the form of April PPI today and CPI tomorrow. The April PPI numbers are out and mostly came in under expectations, and off the peak levels hit in March (2.6% YoY vs. 3.0% in March), ex-food and energy (2.3% YoY vs. 2.7% in March). While the wholesale numbers have been well ahead of the retail-level CPI numbers, producers have found it difficult to pass on much of the wholesale price increases squeezing margins in the meantime. The CPI numbers due tomorrow, however, are forecast to show increases due to higher energy costs with overall CPI expected to increase 0.3% vs. –0.1% in March while core CPI (ex-food and energy) is expected to match March’s 0.2% increase. Year-over-year core is expected up 2.2% vs. 2.1% in March. After moving higher yesterday off the geopolitical news, the 10-year Treasury price is off another 7/32nds to yield 3.00%. The Treasury is auctioning $25 billion in 10-year notes this afternoon so expect trading to be heavy until after the auction as investors look to get that 3-handle yield. Beyond that, 3.033% to 3.047% held in the previous foray over 3.00% so watch that line-in-the-sand.
|Economic News||Financial Conditions Index Tightest Since August 2017||Agency Indications|
While the jobs report from last Friday lent further support to the Fed’s expected rate hike next month, the lack of an acceleration in wage growth remains the one missing ingredient given all the other labor indicators. The monthly gain annualized was just 1.8%, while the year-over-year gain was 2.6%. With inflation creeping closer to the Fed’s 2% benchmark, these wage numbers suggest real wage growth—net of inflation--is decelerating. Be that as it may, as long as other employment indicators point to a tightening labor market the Fed will continue their quarterly hiking pace, content that a tightening labor market will eventually give way to higher wages.
One of those other labor market indicators is the unemployment rate. After six months at 4.1%, the rate dropped to 3.9%, a level last seen in December 2000. The Fed, in their March forecast, was not expecting 3.9% until the end of this year. With no hiccups expected in job gains on the horizon, the FOMC will most assuredly lower their unemployment rate estimate when they issue refreshed forecasts at the June meeting.
Also, given the lack of wage growth acceleration, the Fed’s 4.5% estimate of full employment seems too high but they may resist pulling that down at the June meeting. It’s more likely they want to see stronger wage growth to confirm the economy is operating above full employment and then see such overheating reflected in higher inflation. And they are likely to want more than just a few basis points of higher inflation, thus, the “symmetric” qualifier added in the last statement about the 2% inflation benchmark.
In a speech on Monday, Atlanta Fed President Raphael Bostic told conference attendees in Amelia Island: “We’re fluctuating around the 2% target. I am comfortable with that. To the extent we have seen some upward pressure we don’t have the ability to stop trends on a dime. Some overshoot is fine.’’ So, almost as if on cue we’re getting a little more insight into the “symmetric” phrase. Allowing inflation to run to say 2.5% could become the next new normal given the post-FOMC rhetoric and that would also give them more time to more fully assess the labor market and what level of unemployment now constitutes full employment.
What will be interesting in the upcoming June forecasts will be whether they call for core inflation to ease over 2% for a couple years before returning to 2% in the longer-run forecast. Right now those forecasts are capped at a 2.1% median for all years in the forecast. With the “symmetric” addition they have given themselves some room to bump those forecasts a tad higher. It will also give them quite a bit of leeway to accept lower unemployment and given the behavior of wages so far, it’s not likely that we’ll see a sharp uptick in wage growth that would upset the Fed’s gradualist approach.
Also, given the Fed’s professed aversion to wanting to induce an inverted yield curve, how many tightening events could be left until the yield curve flattens? Three more hikes this year puts the fed funds rate at 2.5% and the 2-year Treasury most likely at 3%, or higher. If the 10-year yield remains range bound near that level it seems possible the flat to inverted curve moment could come by the end of the year, forestalling further rate hikes.
That year-end rate level would also put the funds rate very near the latest estimate of the neutral real rate (the policy rate that is neither accommodative nor contractionary). That provides another logical point to pause the tightening. The caveat to this scenario is long-end yields edge higher for reasons like outsized growth, inflation, and/or supply. We don’t think those drivers are present in sufficient force at this time, but if one or more did appear, long yields could move higher allowing the Fed to keep hiking in 2019 before the curve inverts. That would certainly move them beyond the neutral real rate and clearly into a tightening policy regime.
Financial Conditions Index Tightest Since August 2017
The Fed may still think they are in an accommodative mode, and the fed funds rate is still under the neutral real rate, but financial conditions are getting tighter. The Goldman Sachs Financial Conditions Index, after bottoming with year-end off tax cuts, has begun tightening once again retracing to levels last seen in August. While the index reveals several periods of much tighter conditions, the bounce off the year-end bottom does show financial conditions, between higher rates, portfolio run-off, and some spread widening, has begun to be reflected in a definite tightening in financial conditions.
Agency Indications — FNMA / FHLMC Callable Rates