By Marvin Loh, Senior Global Market Strategist, BNY Mellon
- Strong employment report last week pushes odds for a 4th hike in 2018 towards 80%
- Recent Fed speak from doves and hawks remains consistent towards a continuation of gradual hikes
- While flattening curve and EM volatility creates concerns, data and loose financial conditions continues to support Fed view
By all accounts, the economy is evolving exactly as the Fed expected. As the attached table indicates both growth and inflation are essentially meeting or exceeding the Fed’s 2018 targets. The employment rate reached what was thought to be the natural rate long ago and nonetheless shows no signs of slowing its march further into the full employment zone.
U.S. growth is currently the strongest in the developed world and is largely expected to maintain that pole position in 2019. The most recent GDP reading (4.2% for 2Q:18) more than doubled trend and this positive momentum appears to be continuing into the current quarter. The positive outlook caused Bullard to recently hint that he may lift his long term growth estimates beyond the 2% he has projected for 2020 and beyond.
From an inflation perspective, the Fed is in an envious position amongst the world’s central bankers of having essentially met its inflation goals. All broad measures of consumer and producer prices are higher than the start of the year, while the most recent readings of PCE and CPI are at or above the de facto 2% target. Even the long dormant Phillips curve appears to be waking from its slumber, with y/y average hourly earnings increasing to its highest level in 9-years. Other internals from last week’s employment report are encouraging in at least maintaining recent gains.
Gradual become a mantra for doves and hawks alike
This positive outlook has been evident in Fed speak all summer, through Jackson Hole and even recently amongst the doves. Included, we would highlight Brainard’s comments today that gradual hikes remains appropriate for the next few years, which would likely push funds above the neutral rate. Chicago’s Evans, considered one of the more dovish voices on the Fed also recently echoed this same outlook. While Kashkari and Bostic (both also doves in our spectrometer) stopped short of advocating a push into the restrictive zone, they nonetheless advocate at least getting to the neutral rate which is still several hikes away.
As expected, the centrist to hawkish contingent has remained on message, with no apparent deviation from the dots or concern over the flattening of the curve. It is worth noting that the doves continue to express concern over the flattening and possible inversion of the curve, setting them apart from the broader consensus.
Firming 2018 expectations – Skepticism remains on 2019
The combination of data and Fed speak has recently pushed the odds of a 4th hike in 2018 to their highest levels of the year. The possibility of a 3rd hike this year during the September meeting has been a foregone conclusion for the better part of the summer. That has not been the case with a December hike, which was assigned just even odds as recently as June. This has recently approached 80%, jumping 15 percentage points since the non-farm report. We had been leaning towards a possible pause in December, but have recently joined the majority given the aforementioned discussion points. We now expect that the FOMC will continue to signal a 4th hike in their September projections, which has proven an accurate year-end forecast tool since it started to raise rates 3-years ago.
While investors have warmed to the Fed’s 2018 expectations, the same cannot be said of its 2019 outlook. The attached chart shows the implied odds that the Fed reaches its median funds targets implied by the Dots chart for both 2018 and 2019. As can be seen, while 2018 odds have increased significantly over the past few months, the outlook for 2019 remains largely unchanged. Futures presently expect only 1.5 additional hikes in 2019, which places the odds that the Fed will reach its goal of 3 hikes next year at just 15%. Investor outlook for 2020 is also little changed from the 2019 view, implying that expectations are for an end to the rate hike cycle relatively soon.
Short and longer yields have responded in kind, with the curve bear flattening towards their low spreads of the year. While the rise in 10y yields since Friday’s employment report have been the most significant and sustained of the summer, they nonetheless remain firmly ensconced in one of the narrowest ranges in history. As can be seen in the attached chart, 10y yields have traded within a 20 bps range (2.8%-3.0%) since June. Additionally, while inflation data has firmed throughout this period, breakevens (represented by the red line) have been in an even narrower range. The same can be said of forward inflation expectations, with 5y5y forwards trading within a 10bps range since early June.
What can go wrong?
In order to balance this apparently dichotomous view, we think that significantly tighter credit conditions would need to emerge rather quickly. The recently volatility in the emerging market’s certainly provides a reason to be concerned. With declining central bank liquidity and higher rates often cited as a catalyst for this volatility, conditions may yet become more challenging for the developing world. Not only is the Fed likely to raise rates another 50 bps this year, but the pace of Fed balance sheet reduction will increase again in coming months, reaching its targeted apex of $50 billion/month. The ECB is set to join this party, reducing its 30 billion euro in monthly buying by ½ before completely phasing it out by year-end.
Naysayers also remain concerned that fed funds has traded above the targeted midpoint for the better part of the year, presently sitting 3 bps from the IOER rate and 8 bps from the upper bound. We are in the camp that the effective rate will continue to creep higher towards IOER, requiring yet another 5 bps adjustment to the spread between IOER and the upper bound by year end. It is however questionable if the Fed would be concerned with the creep in the Funds rate so long as it remains within the band.
Broad concerns over political developments, including tariffs have also not yet made their way into U.S. data. Brainard essentially stated as much, although she also referenced increased global uncertainty created by trade tensions. Therefore, continued supportive data will allow the Fed to maintain its gradual hiking stance.
Looking at the performance of the corporate bond market also reveals limited financial stress. The corporate bond market had its busiest week of the year last week, selling $55 billion in new deals. Issuance this week also remains robust, with $30 billion in sales a good target. Overall spreads have nonetheless been mostly stable over the past few weeks, with minimal concessions needed in the primary markets. High yields spreads also continue to compress relative to the IG market, with the implied risk premium between the markets near levels last seen before the crisis.
The Fed is therefore likely to remain on message when they meet in a few weeks as financial conditions remain easy and data continues to point towards above trend performance. Investors may therefore find themselves offsides if the gradual, but relatively aggressive rate hike message continues into 2019.