Fed Minutes Analysis - Other Risks The Fed Mentioned: Inverted Yield Curve
Fed Minutes Analysis - I will continue my discussion in a previous article of the risks the Fed mentioned in its Minutes. The Fed mentioned the yield curve again, but ultimately since it is expected to raise rates in September, it doesn’t seem like it matters. It’s just lip service, meaning the Fed will invert the curve.
On Wednesday, the 10 year yield fell one basis point to 2.82% and the 2 year yield fell one basis point to 2.59%.
This means the difference in the curve is still 23 basis points. That’s very low.
There’s always the possibility that the curve can stay this way for a while, but with slowing growth and inflation, I expect the 10 year yield to stay below 3%. With 3 rate hikes coming in the next 12 months, I expect the 2 year yield to get close to 3%.
I expect an inversion to occur in the next 6 months. The inversion is up to the Fed, meaning the Fed isn’t a third party viewer like me. If the Fed were to announce it is stopping rate hikes after the one in September, then the curve would steepen.
Fed Minutes Analysis - Fed Funds Futures
The Fed is beholden to what the market expects, but it also effects the Fed funds futures market through guidance. The expectation for one 25 basis point rate hike in September went from 93.6% to 96% on Wednesday. This hike has been priced in for a while.
The real action is in the expectations market for a hike in December.
The chance of another hike in December stayed almost the same as it is at 62.8%. The threshold for a rate hike is usually 70%. Lately, there haven’t been many examples of actions the market wasn’t unanimous on.
I think there will be sharp action in the futures market up or down after the Fed makes its decision to hike rates in September and puts out its statement.
The Jackson Hole speech by Powell could also tell us what the Fed is thinking. In the Minutes, the Fed said Powell will be discussing the end of the balance sheet unwind this fall. I expect the Fed to give guidance about ending it in 2020 or 2021.
The Fed has always been transparent and ahead of the curve when it comes to the balance sheet.
Fed Minutes Analysis - Ending Accommodative Policy
The discussion about whether the Fed says it is accommodative or contractionary isn’t just semantics. It tells us where the Fed thinks the neutral rate is. The neutral rate is where rates neither help nor hurt the economy. It’s very difficult to determine the neutral rate.
A quick way to estimate if the Fed funds rate is contractionary or accommodative is to compare it to inflation.
The Fed funds rate is 1.91% and headline year over year CPI is 2.9%. With two more rate hikes this year, the real rate will be about -0.5%. Since the Fed is expected to hike rates twice next year, real rates might be positive next year.
My thesis has been that the fiscal stimulus makes it look like policy is accommodative, but it is actually either at the natural rate or contractionary. If the fiscal stimulus was taken away and GDP growth was 2% in Q2, everyone would be talking about how the Fed has rates too high and that a recession is coming in 2019.
The Fed said in its Minutes that the “accommodative” term is likely going to be removed from the Fed statement “fairly soon.”
I have expected the Fed would change the Fed statement after the September rate hike, but “fairly soon” to me implies the Fed will do it with the December rate hike. It’s also interesting what the Fed decides to change it to.
It’s not binary, meaning the choices aren’t either contractionary or accommodative.
I expect something along the lines of neutral. The Fed may never want to have contractionary policy because that means it is pushing a recession closer. Why would it do that when inflation is still expected to stay near its 2% goal? However, the Fed can misread what the natural rate is.
It can hike rates 4 more times and think the rate is neutral, but it’s actually contractionary.
It will be difficult to determine this because the economy will be coming off the high of the fiscal stimulus. At that point we won’t know if the end of the fiscal stimulus or rate hikes are hurting the economy. It will likely be a combination of both which leads to a recession in 2020.
Fed Minutes Analysis - New Risk: End Of Fiscal Stimulus
The Fed understands the risks associated with policy, but the question is if it calibrates rates and guidance correctly. For example, it is following the strife in emerging markets and is doing nothing to address it. The new risk added to the list in the Minutes is the risk the stimulus doesn’t help the economy as much as expected.
I think the big boost in capex spending can’t be repeated in 2019 and beyond, which means growth will slow. The fact that I call the tax cut and spending boost a stimulus explains my position.
Fed Minutes Analysis - Inflation
The Fed expects inflation to stay near its 2% target, but tariffs can cause it to spike. The Minutes said, "Reports from several Districts suggested that firms had greater scope than in the recent past to raise prices in response to strong demand or increases in input costs, including those associated with tariff increases and recent rises in fuel and freight expenses."
Tariffs are causing some areas to face price pressures, but it will only get bad if more comprehensive tariffs are passed. Wage pressures will increase as the labor market gets tighter.
Fed Minutes Analysis - Stock Reaction
As usual, there wasn’t much of an equity reaction to the Minutes because there wasn’t a change in policy. The S&P 500 was down 4 basis points, the Nasdaq was up 0.38%, and the Russell 2000 was up 0.26%.
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