Yield Curve Still Flattening Relentlessly

The day of reckoning for the Fed may soon be at hand. With the yield curve continuing to flatten and the 10-2 spread falling to a meager 33 basis points this week, an inversion before the end of the year is not out of the question. At that point, the Fed will need to choose between sticking with their current rate path or heeding the recession warning of the yield curve and pausing or perhaps even cutting. The latter option could send stocks higher while recession lurks behind the former.

Money flew to the safe haven of U.S. treasuries this week as investors weighed the potential impact of trade wars and shied away from stumbling emerging markets. With the Fed still signaling further rate hikes, the weight of these flows fell on the long end of the yield curve instead, pulling down the gap in rates between 10 and 2 year treasuries to just 33 basis points.

The flattening of the yield curve by itself does not necessarily indicate trouble ahead. It’s inversion (a negative spread) or nothing when it comes to using the curve as a recession signal. But we are moving closer to an inversion, close enough that an inversion this year cannot be ruled out.

How will the Fed react to a yield curve inversion? They can heed its warning as arguably the most reliable recession indicator or decide this time is different. If this time is not different and the yield curve signals recession in the making as in the past, then continuing rate hikes would be a clear policy error that would tip the economy into recession. Undoubtedly, that recession would weigh on earnings and by extension equity prices. And tripping the economy into recession would likely put monetary policy back into unconventional territory as the Fed’s interest rate tool lacks the 500 basis points needed to address a recession.

Alternatively, the Fed could shift to a wait and see mode if the yield curve inverts. As I argued this week, Federal Reserve Chairman Jerome Powell does not appear sufficiently concerned about inflation to keep hiking rates if the economy stumbled or was threatened by financial unrest. That’s would be good news for stocks. Recall that the stock market soared after the Fed stopped hiking rates in 1995 after a flat 1994. Taking a recession off the table would almost certainly support expectations of higher future earnings.

But which choice will Powell & Co. make? It is not clear that central bankers would see an inverted yield curve as a sufficient threat to the recovery to revisit their rate hike plans. Importantly, consider the current economic environment. In the second quarter, growth might exceed 4 percent at a time when the unemployment rate is already 3.8 percent. Even with inflation low and stable, there will be enormous pressure on the Fed to keep hiking rates even if the yield curve were to invert.

With this economy, what prompts the Fed to react to an inverted yield curve? A clear and convincing threat like that posed by the Asian Financial Crisis. If the inversion results from a sharp drop in long yields driven by such a substantial financial market disruption, the Fed will likely react.

But absent a financial market disruption, the Fed may rely on the argument that the yield curve is inverting at a low level of rates due to a low term premium and as such policy is not really as tight as it may seem. In other words, nothing to see here, folks.

Bottom Line:  It may indeed be true that this time is different. Still, given the yield curve’s track record in past cycles, the Fed ignoring an inverted curve at the 10-2 horizon and pushing ahead with rate hikes would put me on recession watch. That recession though would still likely not emerge until another year or more passed after the inversion.

The Fed Has Enough Room to Combat the Next Crisis

The big news from Federal Reserve Chairman Jerome Powell last week was not so much that he still sees the need for further interest-rate increases despite signs of trouble in the global economy. Rather, the surprise was that he doesn’t believe the U.S. economy is poised to overheat. The takeaway for markets is that there is no impediment to the Fed shifting to a more dovish stance should the economy stumble.

Continued at Bloomberg Opinion…

No, A Recession Is Not Likely In The Next Twelve Months. Why Do You Ask?

Headlines blared the latest recession warning today, this time from David Rosenberg of Gluskin Sheff & Associates. The culprit will be the Fed:

“Cycles die, and you know how they die?” Rosenberg told the Inside ETFs Canada conference in Montreal on Thursday. “Because the Fed puts a bullet in its forehead.”

I get this. I buy the story that the Fed is likely to have a large role in causing the next recession. Either via overtightening or failing to loosen quickly enough in response to a negative shock.

And I truly get the frustration of being a business cycle economist in the midst of what will almost certainly be a record-breaking expansion. Imagine a business cycle economist going year after year without a recession to ride. It’s like Tinkerbell without her wings.

But the timeline here is wrong. And timing is everything when it comes to the recession call. Recessions don’t happen out of thin air. Data starts shifting ahead of a recession. Manufacturing activity sags. Housing starts tumble. Jobless claims start rising. You know the drill, and we are seeing any of it yet.

For a recession to start in the next twelve months, the data has to make a hard turn now. Maybe yesterday. And you would have to believe that turn would be happening in the midst of a substantial fiscal stimulus adding a tailwind to the economy through 2019. I just don’t see it happening.

As far as the Fed is concerned, I don’t think we are seeing evidence that policy is too tight. The flattening yield curve indicates policy is getting tighter, to be sure. But as far as recession calls are concerned, it’s inversion or nothing. And even inversion alone will not definitively do the trick. I think that if the Fed continues to hike rates or sends strong signals of future rate hikes after the yield curve inverts, then you go on recession watch.

With inflation still tame, however, the Fed may very well flatten the yield curve with two more hikes and then take a step back. To be sure, it will be hard to stand down or even reverse course on the yield curve alone. After all, the yield curve is a long leading indicator. It will be the outlying data. But there is a reasonable chance the Fed will not tempt fate in the absence of a very real inflationary threat.

Let’s say for the sake of argument that I am wrong and the Fed inverts the yield curve in December of this year, keeps hiking, and doesn’t try to reverse course until it is obviously too late. Furthermore, assume the inverted yield curve foreshadows a recession like in past cycles. That means at least a year and maybe two before a recession actually hits. So the minimum timeline to recession is 18 months, even if everything goes right (or is it wrong?).

Also, we really shouldn’t discount the possibility that the Fed pauses even before a yield curve inversion. A market disruption from a trade war or external financial crisis that threatens to spill over into Main Street could put the Fed back on the defensive. So the whole story that the Fed will soon kill this expansion is a bit premature.

Bottom Line: The business cycle is not dead. The future holds another recession. But many, many things have to start going wrong in fairly short order to bring about a recession in the next twelve months. It would probably have to be an extraordinary set of events outside of the typical business cycle dynamics. A much better bet is to expect this expansion will be a record breaker.

Retail Sales, CPI, In The News

Quick update on the data. First, the retail sales report reveals that the consumer rebounded solidly from a first quarter slowdown:Never, never, never underestimate the U.S. consumer’s willingness to spend! As long as they have the means to spend, they will do so. And today’s weekly read on the labor market doesn’t provide any hints this will be a problem anytime soon:

With the job market still chugging away like the Energizer Bunny, consumers will continue to have the means to support spending. In the meantime, CPI firmed in May but isn’t setting off alarm bells as core inflation remains low, easing back from a jump earlier in the year:

Interestingly, shelter inflation re-accelerated in the past few months, which is something to keep an eye on:

Altogether, no reason to think the Fed will pause at the September meeting. Baseline is that they keeping grind away with 25 basis point hikes each quarter.

Finally, shameless self-promotion:

FOMC Recap

The Federal Open Market Committee (FOMC) completed their June meeting with a 25 basis point rate hike, bringing the target range for the federal funds rate to 1.75-2.0 percent. The accompanying Summary of Economic Projections (SEP) revealed a modestly more optimistic outlook, as expected. The improving outlook prompted an upward revision to rate hike expectations with the median policymaker anticipating four rate hikes this year, up from three in March. The Fed dropped the explicit forward guidance language in the statement as they work to encourage market participants to undertake a more nuanced, data-driven approach to assessing the future path of rate hikes.

With the economy chugging along at a respectable clip that could exceed 4 percent in the second quarter, the Federal Reserve upgraded its assessment of growth from “moderate” to “solid.” Expected growth for 2018 as a whole rose from 2.7 to 2.8 percent while the unemployment forecast fell from 3.8 percent to 3.6 percent. If history is any guide, that forecast remains too pessimistic given the expected pace of growth this year.

The longer run estimate for unemployment held at 4.5 percent, but the upper end of the central tendency dipped from 4.7 to 4.6 percent. Assuming no significant uptick of inflation, I expect the longer-run unemployment estimate to fall if the actual unemployment falls faster than the Fed expects.

Inflation projections edged up for 2018, but expectations for core-inflation for 2019 and 2020 remained unchanged at 2.1 percent. Essentially, the forecasts imply that a slight bump in the expected pace of rate hikes from three to four rate hikes this year is sufficient to contain the inflationary implications of the modestly better economic forecasts.

To be sure, the Fed’s expectation that they will deliver a full four rate hikes this year should not come as a surprise. Indeed, I would argue that the two low dots in the March SEP were effectively irrelevant for the likely path of policy and eliminating those dots would shift the median projection to four rate hikes. In other words, the median policy maker was already so close to four hikes for 2018 that the bar to making it official this month was very, very low.

The median policy maker anticipates another three rate hikes in 2019. Policy makers also expect they will still raise rates to an above neutral 3.4 percent in 2020 while the longer-run neutral rate held at 2.9 percent. Any “hawkishness” in this SEP reflects the slight acceleration in the pace of hikes; the end game, however, remains unchanged.

The Fed continues to describe policy as accommodative, but dropped language indicating that policy would “remain, for some time,” accommodative. This needed to change given that the lowest estimate of neutral sits at just 2.3 percent, the Fed could be pretty close to neutral with just one more hike. Eventually too they will drop the description of policy as accommodative as rates move closer to the median estimate of neutral.

As policy edges closer to neutral, the exact timing of future rates hikes will become more data dependent. That said, make no mistake that the Fed continues to signal that rates will continue to rise at a pace of roughly 25 basis points per quarter given the expected pace of growth. I would not underestimate the Fed’s resolve in this matter. I expect this pace to hold for the next four quarters if the Fed’s forecast continues to be realized.

Bottom Line: Pay attention to the interplay of the rate and economic forecasts and the flow of data. The pace of data will almost certainly not slow sufficiently to prevent the Fed from hiking in September and probably December. I would say September is essentially a lock at this point. I also think you need to pencil in rate hikes in March and June of 2019. Recognize though that by mid-2019 the data might reflect the lagged impact of past tightening and the yield curve is likely to be fairly flat; both factors would slow the pace of rate hikes. The Fed will face a more difficult choice if the data holds strong while the yield curve inverts.

June 2018 FOMC Meeting Ahead

Central bankers are set to hike interest rates at this week’s meeting of the Federal Open Market Committee (FOMC), an outcome widely expected by market participants and thus should come as no surprise. The economic projections will probably look a little stronger relative to January. I don’t anticipate large changes to the interest rate projections for 2019 and 2020; the general story that the Fed expects rates to rise above neutral will still hold. The 2018 median projection will likely rise to reflect a full four rate hikes this year (that only takes the shift of a single dot).

Attention will fall heavily on changes in the accompanying policy statement given expectations that the Fed will try to reduce market reliance on forward guidance in the statement and at least by default raise the importance of the forecasts. This shift risks creating more uncertainty about policy than the Fed intends because unlike the statement, the forecasts do not represent a consensus view of policy. Be prepared for more noise as policy makers may more often stake out public positions that appear at odds with those of key policymakers. To navigate the noise, focus additional attention on the statements of permanent FOMC voting members.

The minutes of the May FOMC meeting first hinted of a change in the statement the Fed issues to explain its policy decisions. The descriptions of the policy rate as “accommodative” and“likely to remain, for some time, below levels that are expected to prevail in the longer run” will soon be no longer valid. With just two more rate hikes, in June and likely September, policy rates will be at the low end of the estimate range of neutral policy. This near-term path of policy is thus at odds with the current language.

Moreover, as I explained here, the Fed will turn off the autopilot – the expectations of gradual, once a quarter, 25 basis point hikes – by the end of this year. Once policy rates are in the neutral range, central bankers recognize policy will be increasingly dependent on the expected path of the economy. It is thus more difficult to make promises of future policy.

Any headlines that interpret the changes as an end to forward guidance would be overstatements. The Fed will be changing the language of the statement to match reality. They won’t be abandoning forward guidance entirely. For example, they will retain the “dot plot” of monetary policy expectations. This means that while central bankers reduce the forward guidance provided in the statement, they will by either default or intention increase the importance of the forward guidance provided by the Summary of Economic Projections (SEP). The SEP informs on the Fed’s reaction function, or how its policy approach will change in response to evolving economic data. Via Reuters, here is incoming New York Federal Reserve President John Williams on the communication shift:

“…I think we just need to frame that where the economy is and how we are thinking about policy going forward a little bit differently. And when I say a little bit differently I mean less forward guidance in the language, less language about where we see policy moving, not necessarily no language about it, but less language about it. And more, I think, just trying to express as effectively as possible our views on the economic outlook, how policy fits into that economic outlook, and then use the quarterly economic projections, along with obviously the dot plots, to help put some numbers and some facts and figures that kind of fit in with those statements….

“What we should be explaining to people as much as we can is our reaction function, helping people to understand how monetary policy responds to the changing economic outlook in the context of our dual mandate goals. Trying to put that into words… sometimes just is hard to do and not that effective.

This shift in emphasis will increase the uncertainty surrounding the path of future rate hikes. Partly this is a feature, not a bug. It simply reflects the reality that policy makers will be less sure of the path of rates after reaching a neural policy stance. The risk for financial market participants is that this shift in emphasis raises uncertainty not only from the economic outlook but also from the “cacophony of voices” problem as policy makers take public positions on the path of rates that appear at odds with each other.

The problem of relying more heavily on the SEP is that unlike the statement, the economic projections do not represent the consensus of central bankers. Each policy maker provides an independent forecast. We have become accustomed to using the median of the SEP forecasts as a proxy for the consensus view of the FOMC, but this is not accurate as no such consensus view exists.

I suspect we are going to see policymakers attempt to both raise the importance of the forecasts as Williams does above while at the same time downplaying the relevance of the dots. That’s a recipe for policy confusion. More look at this, but don’t really look at this. In addition, policy makers will further aggravate the confusion because they also find the median forecasts useful as a baseline. For example, see Federal Reserve Governor Lael Brainard here.

Bottom Line: The Fed is set to hike rates this week and change the communication strategy. To navigate this change, first recognize that altering the current forward guidance in the statement does not mean the Fed is shifting to a more hawkish stance as it by itself shouldn’t impact the expected path of rates. Any shift in the path of rates will be driven by the data. It will increase the uncertainty of the timing of future policy changes. Assessing the path of policy will become more difficult especially because the Fed lacks an official consensus outlook for the economy and interest rates. Beware the cacophony of Fed speak. There will be risk of confirmation bias as it will be easy to find a policy maker whose views conform to your own. Instead, watch carefully how incoming data is shaping the opinions of permanent FOMC voting members as they are people that will be driving policy outcomes.

Data Still Coming in Strong

Incoming data on the manufacturing and services sectors as well as the job market continue to support a narrative of strong growth that will encourage the Federal Reserve in its campaign to push policy rates to the neutral level. Will they push beyond? The anecdotal stories in the ISM reports hint at an economy on the verge of overheating, but until that overheating shows up in wages or prices, stories are all they are.

The ISM reports on the manufacturing and services sector were solid for May, both for headline and internal numbers. Particularly noteworthy were the rising supplier deliveries times as firms are unable to keep up with demand due either to production or shipping issues. These concerns are evident in the anecdotal evidence from respondents which largely speak to material and labor shortages. Concerns about tariffs also figure prominently as the resulting uncertainty and higher costs only exacerbate the problems of already tight supply chains.

While the prices paid measures in both the manufacturing and services sectors remains high, it is important to remember that these measures are not a strong indicator of consumer inflation. Still, the economy is heading into a zone not seen in decades – really, since the late 1960’s. In many ways, we really don’t know what comes next or which of the old lessons apply to the new economy.

Similarly, job openings in the JOLTs report climbed higher, helping the labor market reach a new milestone in April as the ratio of unemployed workers to jobs fell to 0.95, the lowest since January 1970. That means there is more than one job available for each unemployed person. One would think that this should lead to faster wage growth, yet show far the wage gains remain fairly anemic. But perhaps a switch will actually flip and employers will lose the ability to control wage gains.

Bottom Line: The data flow continues to speak to an economy that grows increasingly tight with each passing month. That will keep the Federal Reserve in play; they will not easily bring rate hikes to a halt with the economy marching forward and threatening to blow well past full-employment. But has the economy exceeded full employment? Maybe, and there is a chance that wages and prices are only lagging the rest of the data. If so, the second half of this year will get interesting if the Fed faces a combination of ongoing strong growth and actual inflation. To be sure, they won’t get nervous about a modest overshooting of their inflation target. But if they see inflation moving sustainably toward 2.5%, they will feel compelled to act by pushing rates past neutral.

Rate Hike Coming

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The April employment report hammered down the last nail in the coffin that is the June rate hike. It is virtually inconceivable that the Fed would skip a rate hike this month; only a financial meltdown would stay their hands at this point. And they won’t stop with this next hike. Given the path the economy currently follows, they will continue to hike rates up to neutral before they become willing to slow the pace of tightening.

Nonfarm payrolls grew by 223k in May, outpacing consensus of 190k. Despite concerns that the economy runs short of workers, the labor numbers can still eek out job growth in excess of 200k. Over the past three and twelve months job growth has averaged 179k and 197k, respectively.This pace of growth promises to place downward pressure on the unemployment rate. For all of the excitement caused by non-reversing recent gains in prime age labor force participation, overall participation has remained fairly steady just south of 63%. The Fed does not expect it to head higher, believing the opposite more likely as demographic factors kick in into gear and dominate cyclical forces. Policymakers expect something closer to 100k job growth will eventually suffice to hold the unemployment rate steady.

Hence, the Fed fears that sustained job growth at this pace would eventually generate an overheated economy. At 3.8%, unemployment stands at the lowest since 2000. Moreover, most measures of underemployment continue to improve and approach levels not seen since the peak of the last cycle. And further improvement is likely. At a 3.7% rate, which is almost a certainty at this point, unemployment will be the lowest since the 3.5% of December 1969. Arguably, for all intents and purposes the Fed is now in uncharted territory.

It is of course tempting to see the rapid rise of inflation in the late 1960s as the lesson learned from that era. Still, given structural changes in the economy, in particular labor’s lack of bargaining power, it is unclear how that lesson applies now. Indeed, weak wage growth casts doubt on a repeat of the 1960’s anytime soon.

Looking through the monthly ups and downs, the underlying wage growth trend still looks like something close to 2.7%, a fairly anemic pace if inflation sustainably holds at something closer to 2%. That kind of wage growth doesn’t scream “runaway inflation” (especially given that faster wage growth alone does not necessarily transfer into inflation). This will keep the Fed thinking that their estimates of the natural rate of unemployment, currently centered on 4.5%, remain too high.Still, even if their estimate of the natural rate is too high, there almost certainly has to be a point when unemployment falls sufficiently low that behavior shifts to foster more aggressive wage growth. Or perhaps their estimate is correct and the wage response is just lagging the rest of the labor market. And once behavior on wages shifts, perhaps the same will occur for inflation? These concerns nag at central bankers and will only intensify as unemployment drops lower.

Altogether, this drives policymakers to keep pushing up policy rates, wanting to at least reach neutral lest they be far away from neutral should inflation actually accelerate more aggressively. This is the message we will continue to hear from central bankers. How many more hikes will that be? Last week outgoing San Francisco Federal Reserve President and incoming New York Federal Reserve President John Williams told Reuters that policy would reach neutral with three more rate hikes. This largely coincides with my view of the likely path of monetary policy. Two hikes are a given to get the policy rate to the lower bound of neutral estimates, but considering the current pace of activity, I expect the Fed to deliver a bit more with another three hikes this year.

Bottom Line: The employment report indicates the economy retains sufficient underlying strength to justify continued Fed rate hikes. The next will come on June 13. I think a rate hike in September is almost a lock as well; the data is not likely to turn around by then. That leaves a December rate hike still arguably up in the air, but I still believe the economy will retain sufficient momentum to coax the Fed into acting for a fourth time this year and push policy deeper into the current range of neutral estimates.