Tim Duy has his latest Fed Watch:
Coming to Terms with the Fed, by Time Duy: For several months I have watched the disconnect between market participants and the Fed. Such disconnects by definition end only one of two ways; either the Fed moves to the market, or the market moves to the Fed. The market has clearly moved to the Fed over the past two weeks, and analyst after analyst seems to be having a sudden realization that the Fed actually intends to keep rates on hold for the foreseeable future. Moreover, they actually believe that the dominant threat is really higher inflation. No, really.
To be sure, the drumbeat of bearish sentiment was grinding me down as well. I considered the possibility that the Fed would maintain an inflation bias if only to keep market expectations from veering even more toward an imminent rate cut And I had to rethink my whole outlook when John Berry at Bloomberg made his sudden, albeit temporary, foray into the “rate cut is possible” camp.
So what changed so quickly? Was it reduced Chinese purchases of Treasuries? Or problems in the subprime leaking into the broader markets? Or Bill Gross’ sudden change of heart (not so coincidently after bringing former Fed Chairman Alan Greenspan on board?)
I prefer a much more straightforward explanation. It is not simply that Fed policymakers struck forcefully and frequently with what I call “the look through the slowdown” story (for recent examples see Chicago Fed President Michael Moscow, Kansas City Fed President Thomas Hoenig, and Richmond Fed President Jeffrey Lacker, not to mention Fed Chairman Ben Bernanke). Talk can only carry you so far; more important is the apparent confirmation of the Fed’s story via the steady flow of data that argues for a reacceleration of economic activity.
In the last two weeks, we have seen solid readings on both the manufacturing and services ISM surveys, a second consecutive gain on core (nondefense, nonair) capital goods orders, a fall in the inventory to sales ratio as firms work off their excess stockpiles, the trade deficit improve, and the a rebound in NFP after April’s soft read (note that the continued stability of initial unemployment claims at the 300k mark suggests that the labor market remains reasonably solid). All in all, incoming data is forcing analysts to raise their Q2 forecast as high as 4%.
It is worth noting the steepening of the yield curve particular in the 2 to 10 year range, suggests the threat of recession drops considerably a year out, consistent with the Fed’s outlook. And a rebound in Q2 would leave the Fed fully discounting away any stories of a “hard landing” in Q1. But still lurking in the forecast is the housing/consumer story. Early Q2 data (April personal consumption, reads on retail sales) on the consumer is not disastrous, but clearly points to a slowdown from the Q1 pace. Moreover, estimates of mortgage equity withdrawal continue to trend downward as the housing slowdown drags on and on. Still, continued job growth will provide support and my expectation is that consumer spending pulls back to the 2 percent range; slow enough to pull the economy to a pace somewhat below trend, fast enough to forestall a recession – or rate cuts.
Note that I have been consistently surprised by consumer resilience.
Bottom Line: For the moment, the Fed is looking more right than wrong, forcing the more bearish elements of the investing community into a reevaluation of their policy outlook. Has the pendulum swung too far, or not enough? I doubt that question will be answered until the housing market fully washes out. And beware of bears who focus on the downside of every piece of data; the Fed, since Hurricane Katrina, has consistently shown a willingness to look through the soft spots in the data.