Fed Hawkish In 2019?

Fed Hawkish - FOMC Minutes

FOMC Minutes from the September 25th to 26th meeting were released at 2:00 PM on Wednesday.

The Minutes stated, “Participants generally anticipated that further gradual increases in the target range for the federal funds rate would most likely be consistent with a sustained economic expansion, strong labor market conditions, and inflation near 2 percent over the medium term.”

This is a ‘status quo’ statement. Since the Fed has been hiking rates steadily, status quo means the Fed will remain hawkish.

The media presented the Minutes as a surprise given President Trump’s criticisms of the Fed. His criticisms are irrelevant to monetary policy. That is, unless he’s going to replace a member or add members based on a new philosophy.

It’s better to present continued rates hikes as I have which is that they are coming despite recent weak inflation reports.

The Fed appears to be getting as hawkish as the economy and stock market will allow it to regardless of inflation.

Even though the Fed reacts to the stock market, it’s too early in this correction for the Fed to change course.

Stocks need to fall about 12.5% for a rhetoric change to occur. Since this correction started in October, there would be no way for the September Minutes to include a reaction to the decline anyway.

Fed Hawkish - Citi Inflation Reading Falling

As you can see from the chart below, the Citi inflation basket disagrees with the breakeven inflation rate.

It is closer to the latest inflation readings which show weak momentum. Citi inflation reading is based on 250 equities which were put in an index to track inflation.

The inflation basket was highly correlated with the 10 year breakeven inflation rate from mid-2015 to mid-2018.

In the past few months it has been cratering. This is food for thought as we await the September PCE report which comes out Monday October 29th. The prior core PCE report showed core inflation of 2%. I’m expecting 1.9% growth.

Fed Hawkish - Reaction To Fed Minutes

The main movement in the stock market occurred in the morning. It didn’t have much of a reaction to the Minutes.

Expectation of at least one more rate hike by December increased from 79.5% to 83%. The rate hike has been virtually locked in for a few weeks.

If it occurs, the Fed futures market implies there will be 1 or 2 more rate hikes by October 2019. The volatility in stocks has done nothing to impact the Fed fund futures market yet.

On Wednesday, the 2 year bond yield was flat at 2.89%. The 10 year yield reacted to the Fed Minutes by increasing 4 basis points to 3.21%. It’s 5 basis points away from its recent high.

The 10 year yield is 32 basis points above the 2 year yield. This is testing my prediction for an inversion within the next 8 months.

Fed Hawkish - More On The Minutes

The Fed discussed how it no longer claimed to be accommodative in its September statement. Also, the Fed said the term isn’t “providing meaningful information in light of uncertainty surrounding the level of the neutral policy rate.”

That’s very vague language. I interpret that as saying the Fed funds rate is close enough to the neutral rate that policy isn’t accommodative.

We don’t know exactly what the neutral rate is. But we know it will need to increase to prevent policy from becoming hawkish because more rate hikes are coming.

The Fed decided to eliminate the term because keeping it would cause “a false sense of precision” on where the rate is.

Essentially, the Fed is saying after one or two more rate hikes the Fed funds rate might still be below the neutral rate, but it doesn’t want to try to guess exactly where the rate is.

It’s no surprise that the Fed doesn’t know where the neutral rate is. If the stock market and the economy start to falter, the Fed will halt rate hikes regardless of the catalyst of the slowdown.

Additionally, Fed mentioned labor shortages and trade policy as potential catalysts of a slowdown. If labor shortages cause inflation and weak economic growth, it’s tough to say which policy would be appropriate to resolve that issue.

Luckily, the economy is in the opposite situation as growth is strong and inflation is low.

Fed Hawkish - Stocks Decline Slightly

Headlines stated that Wednesday’s action was volatile, but I disagree.

The S&P 500 fell in the morning, bottoming at a loss of 0.88%. It then rallied to the green and closed down 0.03%. That’s not a volatile day, in my opinion.

The only way you can say it was volatile is if your goal is to acknowledge the morning movement. The close makes it look like nothing happened. Nasdaq fell 4 basis points and the Russell 2000 fell 0.45%. The VIX fell 1.25% to 17.40 even though stocks were down slightly.

If you’re a bull, I think it’s good to see stocks digest the major rally on Tuesday.

Bulls don’t want to see the market overbought again. I’m still bullish on the short term. The CNN Fear and Greed index is at 14 which signals extreme fear.

It’s important to realize how normal corrections are. As you can see from the chart below, 2017 was an abnormal year. There weren’t any 5% pullbacks. In 2018, there have been three 5% declines which is slightly below the long term average of 3.3.

Fed Hawkish - Rotation

Best sectors in the S&P 500 were the financials and communication services which were up 1.01% and 0.51%.

Worst sectors were materials, energy, and consumer discretionary which fell 0.83%, 0.69%, and 0.69%.

As you can see from the chart below, there has been a rotation into defensive stocks and away from cyclicals.

This could be a momentary change, but I think it has legs because growth is slowing. This relationship has a good track record of forecasting the economy.

2014 was a growth peak; the cyclicals peaked versus the defensive names in early 2014. The idea of a weakening global economy, hawkish Fed, and a dwindling fiscal stimulus shouldn’t excite the bulls.



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