Even with an interest rate increase probably off the table, the Federal Open Market Committee will have plenty to talk about at its July 13-Aug. 1 meeting.
For starters, there’s the gross domestic product, which grew an estimated 4.1% in the second quarter, with other recent quarters’ growth revised upward. Throw in the potential for escalating trade wars, the flattening yield curve and a discussion of the real neutral fed funds rate and Fed balance sheet reduction, and conversation will flow freely.
It’s unlikely, however, that much of the talk on these topics will become public before the minutes of the meeting are released three weeks later.
“We anticipate some insight on its thinking regarding money market rates, the yield curve, and neutral fed funds to emerge in the August Minutes,” Bricklin Dwyer, U.S. senior economist at BNP Paribas said in its Weekly Macro Matters.
At its prior meeting, where it raised rates, the FOMC issued a new Summary of Economic Projections, which pushed up the expectations for future rates, tweaked the post-meeting statement to upgrade its view of the economy, and dropped wording regarding expecting rates to be lower than long-term levels.
“Given these substantial changes to the statement, we see little scope for further adjustments in August, aside from a few markups on current economic conditions,” Dwyer said. He suggested the statement will note an increase in the jobless rate, which it will attribute to rising participation.
“While not our base case, a hawkish change would see the Committee upgrade its assessment of economic activity to ‘strong’ from the current ‘solid,’” he said.
Others agreed. “The minutes, to be released August 22, could actually be more interesting given the varying comments from some Fed officials on the flattening yield curve,” said Arthur Bass, managing director of fixed income finance and rates at Wedbush Securities. “Inverted yield curves have historically been a leading indicator of a recession, although there is also an argument that long rates are a bit lower than they would otherwise have been due to large buying of coupons by the Fed and other central banks.”
What an inversion of the yield curve would mean has the Fed divided, with several presidents having stated their concern that short-term rates exceeding long-term rates will portend a recession, while a few said it’s not a sign of coming weakness, and some presidents have yet to weigh in.
“We think the August Minutes could give better clarity on where the Committee as a whole stands,” Dwyer said.
BNP sees two more rate hikes this year — which would bring the Fed near or to its projected neutral level — and then one in 2019. “We are of the belief that economic data will begin to show signs of a slowdown next year, as fiscal stimulus fades and the effects of tightening financial conditions and adverse trade policy begin to bite,” he said. “Having successfully overseen rates rising to neutral levels, we envision the Fed allowing itself the flexibility to be nimble and pausing its hiking cycle.”
If the economy grows as expected, said Rich Sega, global chief investment strategist at Conning, the Fed will raise rates “a couple more” times this year. “But given the protracted drag of trade tensions holding us back from the full potential of the administration’s excellent tax and regulatory policies, the FOMC could easily back away and delay if the data warrant it.”
As for yield curve inversion, Sega doesn’t expect it to happen, “at least in the short to intermediate part of the curve” because the Fed “will be careful not to go too far.”
However, he said, “real growth stemming from tax and regulatory reforms should eventually stop and reverse the decline in monetary velocity, the pace of transactions in the economy. That will seep through as inflation, so expectations will play a role in pushing up rates along the curve. We haven’t seen that in a while. So they’re not likely to back away too soon from the planned upward path, not wanting to appear to intervene either way, particularly in an election year.”
Monetary policy gradually rising will make bond price returns “a slight drag on their coupons, which we haven’t experienced much over the past few years," Sega said. “But if it progresses without dramatic lurches upward, bond investors can look forward to buying risk at a better price than they can today.”
Vincent Deluard, global macro strategist at INTL FCStone, also doesn’t believe the curve will invert, “and even if it does, it will not impact lending profitability due to high excess bank reserves.”
“After ten years of QE and monetary manipulations the yield curve has surely lost any predictive power,” he said in a report, suggesting, “Investors should worry less about unpredictable recessions, and more about obvious inflation risks.”
Terming the meeting a “non-event,” Tom Essaye, founder of the Sevens Report, said he doesn’t expect the yield curve to appear in the post-meeting statement. “Bottom line, I think the Fed will reiterate that ‘for now’ ‘gradual’ rate hikes remain the proper course for the markets,” and yields and the dollar won’t move on the statement. “We may see some mild flattening of the curve but it shouldn’t take out the recent lows of 0.24%.”
In his opinion, Essaye said, “the much more important central bank meeting next week is the Bank of Japan meeting (Tuesday). If they ‘fine tune’ their policies to imply a potential reduction in the near term intensity of stimulus, that will send the 10 year yield through 3%.”
The panel seems divided regarding the yield curve. “There is certainly lack of consensus on this issue as well as disagreement on which securities to use to measure inversion (ten-year/two yea spread, ten-year/three month bill spread?),” according to Mary Ann Hurley, vice president of fixed income trading with D.A. Davidson. “Potential headwinds from a trade war will likely be cited. Don’t expect trade to derail the Fed’s monetary policy plan. Members will be concerned about the economic momentum as the effects of fiscal stimulus fades.”
But the amount of accommodation remaining is the Fed’s “overriding concern,” and the panel will remain committed to gradual rate hikes and balance-sheet reduction. “Nothing will likely be added to discourage a September rate hike,” Hurley said.
Brian Rehling, co-head of global fixed income Wells Fargo Investment Institute, said in a report, “We do not recommend that investors assume this time will be different. Yield curve inversion has delivered a powerful message in recent cycles. In our view, it is a message that is unlikely to change through multiple cycles.”
If rate hikes continue, the yield curve will flatten further, and “[a]t some point, it is likely to invert. If this occurs without a corresponding increase in the inflation that the Fed is trying to quash, then we can say that if the curve does invert, the cause will be the Federal Open Market Committee’s (FOMC) action. If this time plays out like the past six in our study, any subsequent U.S. economic downturn would be the result of a monetary policy mistake. In our opinion, an escalation in the Fed’s path of rate hikes would increase the risk of a policy mistake — and if that did occur, it would show up in a flatter yield curve, or even an inverted one.”
September looks like a hike meeting at this point, with December also in the running. “The current odds of a hike [at this meeting] are only 1.3%, and that may be overstated,” said John Donaldson, director of fixed income at Haverford Trust. “Odds for September are down to 80%, having previously been more like 90%, and the odds of another rate hike in December are down to 63%.”
As for defining the neutral rate — the policy level that neither stimulates or restricts the economy — Luke Tilley, chief economist at Wilmington Trust, said in a Bond Buyer podcast, “Because of [Fed Chair Jerome] Powell’s background, I think he’s a little more suspect of anybody’s
Conning’s Sega noted, “No one knows what that rate is, including the FOMC, which is why they’re fishing around for it with gradualism and ‘data dependency.’” He suggested, “We don’t know exactly where it will end up, but we do know that a decade after the end of the last recession, it’s probably at least a little higher than where we are now.”
