Market Remarks: Week Ahead – Sep 24, 2018

What To Expect at Next Week’s Fed Meeting

Fig. 1

This coming week the Federal Reserve is going to conduct the Federal Open Market Committee (FOMC) meeting, its sixth of the year, over a two-day period, followed by a press conference at 2:00 PM on Wednesday September 26th. This will be the third meeting of the year with a press-conference. The other two – in March and June – resulted in Fed-Funds Rate hike of  25 basis points. The odds are very good that Fed will again raise rates next week. That will bring the Fed Funds rate to 2.0%-2.25% range.

Despite having raised rates from <0.25% in December 2015 to <2.00% in June 2018  – a sequence of seven rate hikes in 30 months –  the real Fed Funds rate is still negative (see Fig. 1). With another 25 basis point hike, the usual that the Fed considers in a normal rate-hike cycle – the Fed Funds rate will near breakeven level but it will still not turn positive, which effectively means that the accommodative monetary environment will continue.

In its June 13, 2018 Summary Of Economic Projections, the Fed expected the Fed Funds rate to be 2,4% by the end of 2018, 3.1% by the end of 2019 and 3.4% by the end of 2020. In other words Fed expects two more rate hikes in 2018, three in 2019 and one in 2020. Off course these are projections and they usually change but, nevertheless, the market is already discounting two rate hikes in 2018 as the futures markets indicate a 90% chance of a rate hike in December 2018. However, futures market is less certain about three hikes in 2019, although it the one in March 2019 is more probable.

To maintain a healthy economy the sweet spot for Fed Funds rate is between 2 and 5 percent. Tim Duy of Fed Watch, who pegs the median policy maker estimate of the neutral rate to be 2.9% within a range from 2.25% to 3.5%, says that the Fed’s monetary tightening process should be dependent upon the economic conditions.

Rosengren is correct. There is far too much uncertainty about the path of the economy to assume the Fed will pause when policy rates reach estimates of neutral, particularly the lower estimates. Hence, be cautious of reading too much into claims by central bankers that they expect a pause after three or four more rate hikes. That pause is very conditional on the state of the economy after those increases.

Duy is of the opinion that at the moment Fed doesn’t have reasons to initiate a sustained police pause,

Talk of a pause is currently more about hope than reality. Incoming data remains far too strong for the Fed to contemplate an end to rate increases. Job growth continues at a rate the Fed believes will eventually be consistent with an overheated economy. And there is no reason to expect pressure on the labor market to alleviate anytime soon. Initial unemployment claims continue to trend downward while the number of job openings reached record high in July.

On the other hand are Brad DeLong and Narayans Kocherlakota. Prof. DeLong thinks that it more likely than not he the Fed will be back at the zero lower bound in three years. Prof. Kocherlakota sees recession as the most important risk for U.S. economy in the next two years.

…In the Fed’s view, a low unemployment rate spurs inflation by pushing up wages. But there’s a lot of uncertainty about the magnitude of this effect. If it’s stronger than expected (a steep Phillips curve), then the central bank’s planned interest-rate increases will fail to keep inflation in check. If it’s weak (a flat curve), it doesn’t matter much anyway. So in this case, the Fed is better off erring on the side of action, raising rates faster in the hope of hitting its inflation target. Yet the staff paper downplayed and Powell ignored what I see as the most important risk: that the U.S. economy could face a recession in the next couple years. As then-chair Janet Yellen’s speech at Jackson Hole two years ago revealed, the Fed lacks tools to deal with such a contingency. The best way to prepare is to ensure that the economy is as strong as possible when the downturn hits. And that requires keeping interest rates lower than the Fed is currently planning to do…

We are more in the second camp – DeLong & Kocherlakota – than the first – Duy, Rosengren and Givernor Lael Brainard – and one indicator that we are keeping an eye on is the yield-curve or the 10-Year & 2-Year Treasury spread.

Yield Spread Nearing Zero

Fig. 2

The yield on U.S. 2-Year Treasury Note closed at 2.800% on Friday, a +0.018% increase for the week. The 10-Year Treasury Note closed at 3.064% and gained +0.066% for the week. The spread between them increased from 0.216% to 0.264%, however the trend, since the beginning of 2014, is down for the spread. Historically, when it turns negative then the economy usually gets into recession. In January 2017 we wrote, “Few months before the onset of any recession in the U.S.A – at least since 1980 – the spread between the 10-Year Treasury Constant Maturity and the 2-Year Treasury Constant Maturity has fallen below zero. The economy, on an average, took 15.6 months to dip into recession after the first reading of below zero of this indicator.”

As the spread is still above zero, we do not think that the U.S. will be going into recession anytime soon. However, since Fed Funds rate have a greater impact on shorter term rates and the Fed is getting more hawkish, it behooves us to keep an eye on this spread as a warning sign. Many FOMC members have indicated that though they consider yield-curve turning negative an important point it alone would not change their stance regarding the rate hike for next few cycle.

What’s on Tap – Key Economic Reports

The key economic report due next week include:

Tuesday September 25 – Conference Board Consumer Confidence. The market is expecting a reading of 132.2 versus previous month’s reading of 133.4. This is still a very healthy reading and the up trend since 2009 is maintained.

Wednesday September 26 -New Home Sales – the annualized number of New Homes sold in August is estimated to be 630K versus 627K in July

Thursday September 27.

  • The Final GDP reading is expected to come at 4.2% increase in the Q2 of 2018 from Q1. The last reading on June 28 – for Q1 – was 2.0% compared with the market’s estimate of 2.2%. According to Calculated Risk Blog, Merrill Lynch is estimating 4.4% growth for Q2 and 3.7% for Q3. Where Atlanta Fed’s GDPNow model is estimating Q3 growth of 4.4% and NY Fed’s Nowcasting estimate for Q3 is 2.3%
  • Durable Goods Orders are estimated to have increased by 1.9% in August versus -1.7% in July. The estimate for Core Durable Goods for August is an increase of 0.4% compared to and increase of 0.1% in July

Friday September 28

  • PCE Price Index, Personal Spending and Personal Income: These are critical reports that will show a mixed picture for inflationary pressures. Core PCE is expected to rise by 0.1% in August as compared to 0.2% rise in July, which indicate that the inflation is till contained. Personal Spending growth is also going to be lower in August (0.3%) than in July  (0.4%). Personal Income is estimated to have a bigger growth in August  (0.%) than in July  (0.3%)
    • Chicago PMI reading is expected to be 62.3 in August compared to 63.6 in July
    • Revised UoM Consume Sentiment is expected to be 100.5 versus 100.8 in the previous month


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