Fed's Grip On Rate Narrative Beyond June Has Loosened
Federal Reserve policy makers have been successfully rebuilding their damaged credibility since they startled bond investors and traders with their hawkish comments in the weeks before their decision to raise interest rates in March. And as the calendar moves towards the June 14 Federal Open Market Committee meeting, nothing seems to dent the consensus for a second rate hike of 2017.
The Fed has come a long way from their shaky grip on the policy narrative in 2015 and 2016, when the gap between their forecasts for short rates and market pricing looked like an unbridgeable chasm, leaving them struggling to squeeze in a single hike in December of both years. Even now, many traders are surprised by the central bank’s resolve to boost rates twice in six months, especially when the economy managed to grow at a meager 1.2 percent pace in the first quarter.
For years, the default belief in the bond market was that a Janet Yellen-led dovish Fed would take every opportunity to slow the rate hike cycle, and their continual moving of the goalposts on the strength of the labor market in particular frustrated many economists and traders alike. Now, the Fed’s focus on the potency of payrolls is the primary reason for their forecast of three rate hikes in 2017. The markets have kept the odds of a 25-basis point rate increase in a few weeks close to 80 percent even as the economy faltered in the first quarter and two months of disappointing core inflation numbers reversed the prior upward trend in prices.
While a June hike looks ironclad, the Fed’s grip on the rate narrative for the rest of the year has loosened, as constant political uncertainty and the worrisome inflation data have resulted in what might be termed measured market skepticism. The market’s reluctance to fully price in a third hike in September or any likelihood of a fourth move in December stems from a confluence of economic, political and technical factors.
The economic picture is the least threatening to the bond bear case, as it looks very much the same as every year since the Great Recession: weak first quarters have become the norm, followed by significant rebounds in the second and particularly the third quarters. Economists have dropped their forecasts for the spring quarter a bit in recent weeks, but most still see 3 percent growth as achievable. That would leave the first half right on the 2 percent path that has defined growth in recent years. But the payroll gains have dropped the unemployment rate by 0.3 percentage points already in 2017, to a 4.4 percent reading that has left labor markets extremely tight. One may argue about the quality of the jobs or labor-force dynamics, but when 95.6 percent of the pool are employed and enjoying rising wages, worries about consumer spending look overblown.
The political hurdles to a more aggressive Fed stance are harder for bond bears to overlook. The elevated hopes post-election for quick fiscal stimulus dimmed after the health-care debacle, and eroded further as congressional and FBI investigations on Russian ties to the White House dominated the headlines, distracting lawmakers and distancing the new Trump administration from segments of the Republican-dominated Congress. Many political analysts are now looking to 2018 or later for concrete proposals for watered-down tax reform. Business investment in particular has been delayed by the uncertainty. The initial White House foray on the budget generated very negative feedback from politicians across both parties, and is assumed to be dead on arrival in the Senate, where more mainstream Republicans are determined to seize the reins from the Trump administration.
The final element of the resilience of bond prices over the past few months is more technical in nature. The surprising 45 basis-point drop in Treasury yields in March and April led to heavy losses among speculators, who assumed that the steady raising of short rates by the Fed would translate into higher yields in longer maturities. Those bets proved painful, as the Treasury yield curve flattened sharply, leaving 10-year yields less than 10 basis points off their lows for the year, even as short maturities repriced higher in deference to the Fed.
While the speculative shorts have been covered to a great extent, those bettors aren’t returning to the fray. Instead, a new group of technically-oriented players have seized on the trend and added to long positions in the face of market strength. Those buyers have competed with powerful demand from overseas, where Japanese and Chinese fixed-income investors have shown renewed buying interest in the last few months, still unimpressed with local bond offerings or Europe’s negative yields. Last week’s two-, five- and seven-year Treasury auctions showed moments of weakness, but the large supply bulge ultimately found secure homes, leaving 10-year Treasuries right on the central 2.25 percent yield level once again.
From the Fed’s standpoint, there isn’t much they need to do here. The minutes released last week of the Fed’s May 3 meeting nodded to the weaker inflation data, but showed confidence that the weakness in both inflation and economic growth was transitory. The FOMC can be content with the market’s high assessment of the June odds, with the next payroll report on June 2 and the consumer price index on June 14 unlikely to derail the process. The Fed laid out a very conservative and market-soothing narrative for the tapering of reinvestments and shrinkage of its $4.5 trillion balance sheet, making it very clear that the federal funds rate will be the prime channel for their removal of accommodation. Most analysts expect an announcement of the program in the Fall, but it could easily come sooner, perhaps as early as the July meeting, slipping the tapering schedule into a non-press conference meeting.
Once the June meeting is passed and the fed funds rate is 1.125 percent, the Fed will again be faced with a skeptical market, and a new communications challenge -- convincing the markets they still mean business -- but it is one they have seen before.
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