Dudley Remains Hawkish Despite Disinflation

On Monday, William Dudley stated he expects the Fed to raise rates 1 more time this year and 3 more times within the next 2 years while unwinding the balance sheet. My initial opinion on the Fed’s rate hike was it was a hawkish hike. However, the market didn’t perceive it that way. The market thinks the Fed will realize disinflation is here and slow the speed of rake hikes. Dudley is ignoring this inflation data. The question is when the market will realize the Fed isn’t going to change its mind. Logically, if the Fed hasn’t changed its mind based on the data, there’s nothing that the data can do to make the Fed stop its hikes. As you can see from the chart below, the odds of a rate hike don’t go above 50% until March 2018. Usually the Fed doesn’t raise rates until the chances get above 70% meaning rate hikes aren’t expected for a while. The next few months will either see the odds increase or the Fed change its tone on rate hikes.

The Fed’s hawkishness combined with the low inflation and growth rates haves caused the 30-year bond yield minus the 2-year bond yield to have the smallest difference since the last business cycle. Without the Fed changing its tune, the yield curve will flatten more since the market isn’t fully pricing in the Fed’s guidance. The next rate hike could invert the yield curve.

The chart below reinforces why long-term bond yields are falling and how the Fed is ignoring the data. This chart shows 5-year inflation expectations falling from 2.23% to 1.78%. The reverse of what the Fed is saying is the truth. The latest bout of disinflation isn’t transitory; it was the small blip up in inflation in late 2016/early 2017 which was the transitory movement which was based on optimism about Trump’s election. The move seemed amazing at the time as Trump, without even being in office yet, was able to get inflation expectations higher. Trump had supposedly done what the Fed had spent trillions in QE to do. The reality is Trump wasn’t able keep inflation expectations high because the shift is global and based on long term factors.

The chart below shows Fed policy compared to the core CPI. Although I have explained how inflation would imply the Fed shouldn’t be hawkish, because of where the Fed started with rates, they are still relatively dovish. As you can see, whenever the Fed funds rate has gotten 2% higher than the core CPI, a recession followed. With core CPI falling and the Fed raising rates, that’s a toxic cocktail which will push the Fed to being historically hawkish and push the economy into a recession.

Although the price of oil doesn’t affect core inflation, it’s a big part of the headline number. The price crashed again on Tuesday as it closed at $43.23 which is the weakest settlement since September 16th, 2016. The price of oil is now down 21% from this high earlier this year, putting it in an official bear market. The price fell over 2% because of increased output from Nigeria, Libya, and Iraq who are exempt from the OPEC cuts. Libya’s output improved by 178,000 barrels per day in May and Nigeria’s output increased 174,000 barrels per day. Iraq’s production increased 44,000 barrels which led to the total OPEC increase to be 336,100 barrels per day. With shale production increasing and OPEC increasing production, it’s not surprising to see the price of oil crashing.

The energy sector fell 1.25% on Tuesday as the energy sector earnings outlook continues to deteriorate. The bulls just got used to including the energy firms’ earnings in their great earnings outlook. Now they will have to look at earnings ex-energy because sectors only get to be included when they are doing well apparently. My point about the reliance on tech to drive earnings growth in the 2nd half of the year rings even more true today. Even though I showed the rise in the credit default swaps of energy firms, junk bonds as a whole have matched the S&P 500’s performance. As you can see, the junk bond index has only fallen 0.80% from its recent high.

Getting back to central bank policy, Goldman Sachs agrees with my assertion that the Fed’s balance sheet will only dip lower temporarily before moving higher again just like the ECB did in 2013 and 2014. This unwind will be tougher for the Fed than it was for the ECB because the Fed was doing QE 3 during the ECB’s unwind and the JCB was also buying assets hand over fist. The most hawkish possibility I see is for the Fed to do what is in the chart below. That would be unwinding the balance sheet until 2020 when it reaches about $2.5 trillion and then increasing it again. It’s a weird description to call this the terminal size because it won’t stay at that size for long. This is if everything goes according to plans. If the stock market falls sharply within that period or the economy goes into a recession, the plans will probably be scrapped. If you would have asked me 12 months ago what scenario would lead to an unwind, I would have said one where the market doesn’t ever fall. Well that has happened as the market hasn’t fallen 5% since early 2016. It’s doubtful that trend can continue until 2020.

Conclusion

Skeptics of the Fed’s programs and analysis seem silly with the stock market rallying to all-time highs, inflation being low, and GDP growth likely at a solid 2% in Q2. However, if you break down what the Fed says, it’s illogical. I’m still concerned with logic despite the good current environment. The Fed can go from heroes to villains if the stock market falls during the unwind process and the Fed is stuck with going through with it. Will the Fed stop its unwind if the market falls? That would show the Fed to be focused on the S&P 500 instead of the economic data like we all already know to be true.

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