The reprieve from trade-related bombast was short-lived as the rhetoric has heated up today with the U.S. now eyeing five Chinese video-surveillance firms for blacklisting, in addition to the previous Huawei restrictions. For it’s part, Chinese President Xi called on citizens to join a “ new Long March,” a phrase he’s used before to illustrate achieving progress despite hardship. The actions and rhetoric speak to a conflict that continues to escalate with resolution a distant dream at this point. That has Treasuries back in rally mode as another bout of flight-to-safety commences. Meanwhile, the plethora of Fed speakers this week may have taken some of the shine off this afternoon’s release of the FOMC’s May 1 minutes but they’ll still garner market attention following the 2:15pm EDT release. The Fed speakers, of which we discuss at more length below, have been fairly consistent that policy is just fine where it is. Thus, the patient pause remains the policy of the day, and for the foreseeable future. Meanwhile, the market is convinced the Fed will cut rates by year-end as inflation fails to hit the 2% target. There’s still plenty of time for the data to play out but inflation and its 2% target will be the primary driver of policy for this year (with trade a close 2nd). The consensus Fed view is that conditions remain such that inflation will rise to 2%. The market sees the reality of inflation missing the target for the last seven years and assumes the Fed will eventually relent with a rate cut. How that difference of opinion is resolved will drive trading for the balance of this year with trade war developments providing extra volatility, and right now that volatility is generating higher Treasury prices.
The Atlanta Fed hosted a financial symposium on Amelia Island earlier this week and that accounts for much of the Fed speak we’ve received in recent days. While Chairman Powell delivered the keynote address Monday night, his speech didn’t delve into the current trade imbroglio and what that may mean for the economy and rates. In fact, the title of his address was “Business Debt and Our Dynamic Financial System” and as such his focus was more on financial stability rather than any update on the economic and/or rate outlook.
In any event, he did offer some conclusions in regards to the state of financial conditions and it might be informative to provide his conclusion. To wit, “First, business debt is near record levels, and recent issuance has been concentrated in the riskiest segments. As a result, some businesses may come under severe financial strain if the economy deteriorates. A highly leveraged business sector could amplify any economic downturn as companies are forced to lay off workers and cut back on investments. Investors, financial institutions, and regulators need to focus on this risk today, while times are good.
Second, business debt does not appear to present notable risks to financial stability. The debt-to-GDP ratio has moved up at a steady pace, in line with previous expansions and neither fueled by nor fueling an asset bubble. Moreover, banks and other financial institutions have sizable loss-absorbing buffers. The growth in business debt does not rely on short-term funding, and overall funding risk in the financial system is moderate.
The conclusion and tenor of the comments regards business debt, and specifically business debt in the riskiest most levered segments, as the primary risk for regulators to focus on. That being said, he was quick to add the risk does not appear to threaten overall financial stability and the capital and liquidity buffers in the banking industry appear more than sufficient to handle the risks should losses start to materialize in an economic downturn.
While financial stability was Powell’s keynote address, there were plenty of Fed speakers that did offer up thoughts and opinions on the economy and rates. The general conclusion from most of the comments is that the economy is in a good place and that the patient pause approach seems to be well entrenched at this point. While the market is expecting a 25bps rate cut by December there is little indication that any Fed member was warming to that view, at least not yet.
Atlanta Fed President Raphael Bostic did address the somewhat touchy subject at the Fed of the failure to get inflation to the 2% target. He commented that the Fed hasn't hit its 2% target since 2012 and that, ``is just a reality that raises some questions,'' Bostic went on to say the Atlanta Fed’s models show a jobless rate of 4.1% is the lowest level without spurring inflation; thus, we could see a downward reassessment of this equilibrium unemployment rate which currently is estimated at 4.3%. The fact the current rate of unemployment remains well below this estimate—most recently at 3.6%— and inflation hasn’t shown any signs of flaring, continues to be something the Fed is wrestling with in its modeling and policy stance.
Shifting to the neutral rate, or the fed funds rate that is neither contractionary nor accommodative, the fact wage pressure has been modest is consistent with a view that the policy rate is sitting near neutral. The conundrum between inflation failing to hit the 2% target, unemployment running well below the Fed’s equilibrium estimate, and wage gains failing to accelerate could imply a Fed that is running policy in restrictive territory. While St. Louis Fed President James Bullard thought the December rate hike was perhaps overkill he’s still not inclined to recommend a cut at this point. We say if you don’t have uber-dove Bullard on board for a cut, the full FOMC is a long way from that view too.
A Coming Clash Between the Market & the Fed?
There’s been plenty of Fed speakers this week but one thing that’s been consistent in their comments and opinions is that none are willing to consider a rate cut anytime in the near future. The comments on the economy and rate policy are generally that the patient pause approach continues to serve the economy well and thus there is little need to alter it. The graph illustrates investors are eying a rate cut by year-end. The latest odds of 68.1% imply investors see inflation remaining below the 2% target this year which will force the Fed into cutting. A day of reckoning between the two views seems to be coming.
Agency Indications — FNMA / FHLMC Callable Rates
|Maturity (yrs)||2 Year||3 Year||4 Year||5 Year||10 Year||15 Year|