U.S. Rates Update April 2019

Monthly Commentary

May 13, 2019

The month of April was highlighted by mostly positive economic data in the U.S. and the Fed’s continued focus on inflation. The March employment report beat expectations with a sharp rebound to +196k jobs and small upward revisions to previous month numbers. Although hourly earnings came in on the softer side, average payroll growth of +180k jobs in Q1 does indicate a solid trend so far and is likely to support household income/demand in the medium term. The Q1 GDP reading also surprised to the upside at +3.2% which was well above market expectations. Although this GDP number was mostly driven (1.7% of the 3.2%) by the volatile categories of inventories (likely to reverse in Q2) and net trade, it was a solid number nonetheless and confirms that the weakness in economic activity towards the end of last year was likely temporary. Domestic markets also got a boost from positive global data highlighted by strong export data out of China. The global data was buttressed by a wave of central bank dovishness which included: 1) the Bank of Canada essentially throwing in the towel on their hiking bias, 2) the Bank of Japan extending their forward guidance to “at least” spring of 2020, 3) the Riksbank (Sweden) shifting their projected rate path lower, and 4) a U.K. think tank report on the Bank of England remaining on hold given uncertainty around Brexit. The confluence of this domestic and global data led to risk-on markets in the U.S., wider TIPS break-evens and a higher/steeper Treasury curve. By the halfway point of the month, the long end of the Treasury curve was +16bps higher, the 2s/30s Treasury curve +3bps steeper, 5yr break-evens +9bps wider, and S&P 500 up +2.6%.

The release of the March FOMC meeting minutes was mostly a non-event and in a nutshell revealed an FOMC that was disappointed with recent inflation prints and inflation expectations that were drifting lower. The FOMC recognized that although inflation was running close to 2%, it was “noteworthy” that it hadn’t responded to stronger labor markets. Committee members surmised that inflation expectations were either much lower than widely believed and/or more slack existed in the labor market than previously thought. The bottom line is the minutes revealed a Fed that is far more worried about low inflation expectations than about financial stability risks from keeping rates lower for longer.

This concern over inflation was again highlighted by Fed Vice-Chair Clarida during a speech on potential recessions when he alluded to the Fed’s history in taking pre-emptive action against them. He remarked that when looking back in history, rate cuts were not always associated with recession and there were times in the 1990s (’95 and ’98) when the Fed took out some “insurance” cuts. These were interesting (and surprising) comments by Clarida and reflect concern over the drift lower in inflation expectations. They also explain the Fed’s continued references to the upcoming Monetary Policy Review symposium in June (recall that an item on the agenda is the possibility of a shift in their interpretation of the inflation target). These comments by Clarida implied that the threshold for the Fed delivering a rate cut has been greatly lowered, therefore a slowdown in economic activity was not the only factor the Fed was considering to kick off a “traditional” easing cycle. Based on these comments, even with growth at trend, the Fed appeared biased to cut rates to anchor inflation expectations, solidify their dedication to a symmetric inflation band around 2%, and even potentially engineer an inflation overshoot.

However, by the conclusion of May’s FOMC meeting (4/30-5/1), the sentiment in the market shifted as Fed Chair Powell (somewhat surprisingly given Clarida’s earlier public comments) sounded more upbeat with respect to the outlook for growth, easing in financial conditions and improvement in the global outlook. Most importantly, during the post-FOMC meeting press conference, Powell pushed back against the idea that the Fed is contemplating “insurance cuts” to boost inflation, remarking that the preemptive cuts in ’95 and ’98 were made in the context of “quite different” situations. This sentiment came through most clearly in his repeated references to the Q1 shortfall in annualized core PCE inflation as being “transitory.” Although he again preached patience and no bias in policy, he appeared to be (or was interpreted to be) making a concerted effort to sound more hawkish given the number of rate cuts that were recently being priced into markets. Powell highlighted several transient factors affecting inflation that were likely to reverse, among them: portfolio management services, apparel, and airfares. Before these one-off drags weighed on inflation in Q1, Powell judged that the inflation situation throughout 2018 was “near-ideal,” as core inflation remained very close to 2% even as labor markets turned tight. To filter out some of this noise, Powell even suggested (twice) that perhaps it would be more appropriate to look at alternative (more robust) inflation measures like the Dallas Fed’s trimmed mean PCE. This measure seeks to reduce the statistical noise in monthly inflation readings by trimming out the higher and lowest price changes in the market basket and is currently running closer to the Fed’s 2% target.

Core PCE vs Dallas Fed Trimmed Mean PCE

Source: Bloomberg

The combination of Powell’s hawkish press conference and a surprise cut to IOER , the interest rate paid by the Fed to banks on their excess reserves, whipsawed rates markets to close the month. In between the announcement of the 5bps “technical adjustment” to IOER and Powell’s subsequent press conference where he dispelled the notion of insurance cuts (subsequently endorsed by various Fed officials including Clarida), the 2yr Treasury, for example, traded in an 11bps range (2.20 to 2.31). Additionally, the futures market initially re-priced a full 25bps rate cut to this October only to push it back out to May 2020 after Powell’s comments. Although he stressed that the 5bps cut to IOER was purely technical (not a monetary policy signal) and meant to foster Fed Fund trading within the target band, the market surprisingly ran with an initially dovish read sparking this volatility. At any rate, given firmer economic data and recession fears that are seemingly off the Fed’s radar for now, inflation remains at the forefront of the Fed’s agenda which will likely lead to range-bound rates in the near term.

Source: Bloomberg


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