Hawkish Minutes Force Another Yield Curve Inversion

Hawkish Fed Minutes

The Fed’s Minutes from its late July meeting were released on Wednesday. I think the Minutes were hawkish because the Fed was far from committing to more rate cuts even though as recently as this week, there was about a 50% chance of 3 more cuts by the end of the year. The market has gotten way ahead of itself. The Fed is still stuck on this being a mid-cycle adjustment. It will be interesting to see if Powell repeats what was said in the Minutes in his speech on Friday.

Remember, the July Fed meeting occurred right before Trump announced the phase 3 tariffs. Powell has the opportunity on Friday to set the record straight with this new information by putting forth more dovish guidance. He can even say multiple cuts are on the table. Some people speculate that the Fed alters these Minutes to fit with its latest guidance. I won’t go along with these conspiracy theories. This guidance might not be exactly what the Fed thinks now because there will be tariffs on consumer goods starting on September 1st and December 15th.  

Review Of Minutes Text

First, I’ll look at the language from the Minutes and then I’ll look at how it affected markets. As I mentioned, the Fed sees this as an adjustment rather than a new cut cycle. The Minutes stated, “In their discussion of the outlook for monetary policy beyond this meeting, participants generally favored an approach in which policy would be guided by incoming information and its implications for the economic outlook and that avoided any appearance of following a pre-set course.”

The term ‘pre-set course’ was the most notable one in the Minutes. The Fed is open to any policy and doesn’t have a specific framework already decided. The Fed has far from determined that it will cut rates a certain number of times this year; it’s remaining flexible. It’s always good for the Fed to be open to various paths. However, the market is beyond flexibility. It sees a rate cut in less than a month and potentially 2-3 total rate cuts in the next 3 meetings.

The Minutes also stated, “A number of participants suggested that the nature of many of the risks they judged to be weighing on the economy, and the absence of clarity regarding when those risks might be resolved, highlighted the need for policymakers to remain flexible and focused on the implications of incoming data for the outlook.” The Fed is flexible mostly because of the trade tensions. While the Fed is behind the market, being flexible makes sense because we have no idea what direction the trade war will go in. Economic data is cyclical which makes it predictable. However, intelligent minds disagree with where Trump is headed with the trade war over the next few months.

Those who favored no cut in July believe the economy is good, risks have receded, inflation is firming, and financial stability risks are diminishing. Those who wanted to cut rates 50 basis points saw low inflation. Those who wanted to cut rates once stated inflation is low, cutting rates is prudent risk management, and the economy is slowing because of external headwinds and risks which are the global slowdown and the trade war.

Fed Inverts The Curve Again

The Fed Minutes were hawkish. The Fed funds futures market agrees with that perspective as the odds of the Fed cutting rates just 1 more time this year increased from 5.9% to 11.8%. The odds of 3 more cuts fell from 54.9% to 43.3%. Because the Minutes occurred before the tariffs were announced, this can all change. As for now, the most likely policy went from 3 more cuts to 2 more cuts. We will gain confidence in what the Fed will do after its meeting on September 18th. We should also gain clarity after Powell’s Jackson Hole speech.

It’s no surprise the yield curve flattened because the Minutes were hawkish. The chart below shows the temporary 10-2 year inversion as treasuries sold off modestly. Usually, inversions occur as rates increase because the Fed hiked too much. However, the last inversion occurred as both the 10 year yield and the 2 year yield were falling. Could that uniqueness ruin this signal? It’s possible. I’ll be looking at the economic data to forecast a recession as always. There’s nothing in the data that suggests Q3 will be recessionary.

The latest action in the treasury market on Thursday morning shows the 2 year yield is 1.56% and the 10 year yield is 1.57%. The criticism of the inversion being temporary has less merit now that it occurred again. I’m not surprised it happened because the market moves a few basis points each day typically. As I mentioned, flattening is good news. Now that we had an inversion, the next step towards a recession is steepening. The bulls should want the curve to stay inverted.

Stocks Rally Despite Hawkish Minutes

Even though the Fed far from guaranteed multiple rate cuts by the end of the year, the stock market still rallied, reversing Tuesday’s losses. The S&P 500 was up 0.82%, the Nasdaq was up 0.9%, and the Russell 2000 was up 0.79%. The correction in August was normal. Stocks won’t reach the pace of returns they were at in late July which makes sense because that would make them very expensive. It’s possible that the July 26th high is very close to the high for the year, but also that this correction is mostly over. The one catalyst that can bring a much higher record is the end of the trade war.

On Wednesday the VIX was down 1.7 to 15.8. It signals the market isn’t in a correction anymore. That’s a normal VIX. Mostly because of other markets than the stock market, the CNN fear and greed index stayed at extreme fear as it only increased 2 points to 25. My point that the market has been highly correlated was studied. As you can see, in the past 15 days an average of 416 stocks have moved in the same direction which is the highest since January 2016. Wednesday was yet another example of each sector moving in the same direction. They were all up. The best 2 sectors were tech and consumer discretionary which rallied 1.18% and 1.83%.

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