Tim Duy's Fed Watch

Yes, the Stock and Bond Markets Can Both Be Right

Equities have renewed their rally -- and so have bonds, and that is creating much alarm among some investors. Whereas the former suggests the stage is set for solid growth, the latter and the accompanying narrowing of the yield curve raises red flags about the health of the economy. I am not sure there is much of a puzzle here. This dichotomy is fairly typical of a monetary tightening cycle and can exist for a long time. How long? Until the Federal Reserve finally snuffs out the expansion with excessively tight monetary policy...

Continued at Bloomberg View...

Autos Drag Down Industrial Production, Housing Solid

The Federal Reserve released March industrial production data today. Overall production was up 0.5% supported by a big jump in utilities. Despite the headline gains, it was something of a mixed message. First, the dispersion of weakness was the lowest since 2014:

It looks like with the rebound in energy prices and related production activity, the industrial side of the economy has turned a corner. On a softer note, manufacturing activity tumbled:

This was fairly disappointing considering the long run of solid growth beginning in the second half of last year. Slowing motor vehicle production took a bite out of the numbers. Specifically, autos, not trucks:

That chart makes it fairly clear that Americans prefer big vehicles to small ones. Overall motor vehicle sales are probably past their peak, and we can expect this source of weakness in industrial production to persist until sales settle into a new level. Note that motor vehicle output contributed 0.14 and 0.06 percentage points to overall growth in 2015 and 2016 respectively. That gives some sense of the magnitude of the opposite effect on growth this year - noticeable, but small.

Housing starts were below expectations, but February was revised upwards. Overall, a solid start to the year:

I don't see any reason to believe the uptrend in single family has broken, but multifamily is likely near cycle highs. For more on housing see Calculated Risk here and here.

Yesterday Federal Reserve Governor Stanley Fisher gave remarks on central bank communication.  Of more immediate relevancy were his comments on balance sheet adjustment. Specifically, he doesn't see it as having a disruptive impact:

My tentative conclusion from market responses to the limited amount of discussion of the process of reducing the size of our balance sheet that has taken place so far is that we appear less likely to face major market disturbances now than we did in the case of the taper tantrum. But, of course, as we continue to discuss and eventually implement policies to reduce our balance sheet, we will have to continue to monitor market developments and expectations carefully.

Separately, Kansas City Federal Reserve President Esther George argued for continued rate hikes despite choppy data:

Overall, I am encouraged by the start of the normalization process and want to see it continue. Resisting the temptation to react to near-term fluctuations in the data will be necessary. Looking ahead, we should expect inflation to move up and down around 2 percent. A modest decline in inflation or an overshoot may not necessarily warrant the monetary policy normalization process to slow or accelerate. Such attempts at monetary fine-tuning can easily backfire, so a more forward looking view of inflation is needed.

And as part of that process she would like to see balance sheet reduction placed on auto pilot mode:

Balance sheet adjustments will need to be gradual and smooth, which is an approach that carries the least risk in terms of a strategy to normalize its size. Importantly, once the process begins, it should continue without reconsideration at each subsequent FOMC meeting. In other words, the process should be on autopilot and not necessarily vary with moderate movements in the economic data. To do otherwise would amount to using the balance sheet as an active tool of policy outside of periods of severe financial or economic stress, and would increase uncertainty rather than reduce it.

She also argues against deliberately overshooting the inflation rate. Her key reason is an often forgotten point. Not all goods and services have the same inflation rate, and a higher overall inflation rate may exacerbate inflation differences across the economy. Those differences would be expected to force a restructuring of the economy that could be costly. Her example is that housing costs may accelerate even faster if the Fed were to push for above target inflation:

Such concentration and persistently rising prices in one area suggests the economy is struggling to reallocate resources. For housing, it could reflect several factors such as tight lending standards faced by home builders and scarcity of skilled craftsmen needed to construct homes. I expect the market to eventually solve for, or at least adapt to, such factors. Using monetary policy however to compensate for them could easily end up hurting the population the policy is intended to help.

So count George as a "no" when it comes to any discussion of raising the Fed's inflation target.

Meanwhile, the Trump trade in bonds is reversing course; ten year yields are below 2.2 percent as I write. Also, odds of a Fed rate hike in June have fallen below 50 percent. Market participants are reasonably starting to think that the normalization process may take a bit longer than the Fed anticipates. It will be interesting to see if the Fed agrees. I expect that on average Fedspeak will stick with a fairly hawkish story as policymakers largely dismiss the choppy data of late. We will see if any of George's colleagues share her conviction that policy should not react to recent noise. I tend to think it is a small group, but I argued that Federal Reserve Chair Yellen sounded fairly complacent about the economy last week. Given that the Fed doesn't like to surprise, expect policymakers to speak out forcefully if they feel market participants just don't get it.

Fed Looking Forward to the Second Quarter

First quarter growth is likely to fall flat - at least that is the signal from numerous forecasters and the Atlanta Fed. But what does it mean for Fed policy? Probably not much for now. It will leave policymakers a little cautious as we head toward the June FOMC meeting (May seems most likely a off the table for policy action). But mostly the Fed will be watching incoming data from the end of the first quarter and the beginning of the second. If the data flow picks up over the next couple of months, they will likely move forward with a June hike. They seem to be in a "what, me worry?" frame of mind.

Retail sales stumbled in March, following up on a revised decline in February as well. Motor vehicle sales are partly to blame; we have likely seen the peak in car sales for this cycle and are settling into a lower pace of activity going forward. Lower gas prices and sluggish sales at building supply stores contributed to the fall as well. Stripping out the more volatile components, however, suggests a bit more stability in sales than suggested by the headline numbers:

March inflation came in lower than expected, with a surprise hit to core:

Ocular econometrics suggests the March print is something of an outlier - the first monthly decrease since 2010. A big 7 percent decline in cellular service prices played a roll, as did falling used car and apparel prices. While I anticipate a rebound in April, this kind of print will help keep the Fed's inflation forecast intact thus preventing them from stepping up the pace of tightening. Watch how this plays through to core-PCE inflation. As a reminder, that was running hot in the first two months of the year:

In another sign that the Fed's inflation metrics will remain contained, the PPI for health services remained subdued in March:

The New York Federal Reserve issued its survey of inflation expectations for February. Interesting split between the high and low numeracy groups:

The low numeracy group tends to be more volatile, so I anticipate it will revert back in the next month.

How will any of this matter for the Fed? First, remember that the Fed started dismissing first quarter data at the March FOMC meeting. From the minutes:

Participants generally saw the incoming economic information as consistent, overall, with their expectations and indicated that their views about the economic outlook had changed little since the January-February FOMC meeting. Al­though GDP appeared to be expanding relatively slowly in the current quarter, that development seemed primarily to reflect temporary factors, possibly including residual seasonality.

Hence I don't think they will be surprised by a weak GDP number; they will be surprised if that weakness looks to be carrying forward into the second quarter.

Second, I think the same goes for inflation. For the moment, I think that the decline in unemployment to 4.5% will weigh more heavily on their decisions than a weak inflation number. Still, I believe that if inflation looks to be tracking below their forecasts, they will eventually reduce their estimate of the natural rate. Just not right away. 

Third, I think this take on Federal Reserve Chair Janet Yellen's talk last week from Marc Chandler is accurate:

We had detected a shift in the Fed’s stance that we characterized as looking for data to confirm the recovery to now looking for opportunities to normalize conditions.  Yellen sees similarly.  She said the Fed has shifted from “a post-crisis exercise of healing” to now trying to sustain the economic progress.

The Fed is not living in the crisis anymore. Policymakers no longer worry about trying to boost the pace of activity. The economy is, by their estimates, near full employment with growth is near potential growth. In this framework, a normal economy demands a more normal monetary policy. Policymakers are thinking that the expansion will be eight years old this summer with a good chance that this could turn into the longest running US economic expansion on record. They generally believe that preemptive but gradual rate hikes offer the best chance of expanding the expansion to ten years and beyond. Hence I tend to think their bias is to continue along the current policy path, which suggests they will continue to sound hawkish relative to what recent data would suggest. 

Bottom Line: Fed likely to dismiss recent data as unrepresentative of underlying economic trends. 

 

Solid Employment Report

Labor markets were generally solid in March, with nothing by itself to dissuade the Fed from its current path. We should be watching for the Fed reaction to the decline in the unemployment rate, assuming it persists in the coming months. Could be dovish if the Fed lowers its estimate of the natural rate. Could be hawkish if they see a higher risk of undershooting the natural rate.

Nonfarm payroll growth slowed to 98k:

While this was below expectations, it wasn't a surprise. My interpretation is that most analysts expected downside risk to the estimates based on cold weather in March. No reason to think the basic underlying trend of solid but slowing declining job growth. 

The unemployment rate dipped to a cycle low of 4.5% and stands below the Federal Reserve's longer run unemployment projection:

This will raise some eyebrows at the Federal Reserve. The median FOMC participant forecast 4.5% for December. So we are a little ahead of schedule on that. Does this mean the economy is poised to overheat? The wage numbers do not support that hypothesis:

Wage growth flattened out in recent months, suggesting the economy is not yet in danger of overheating. Policymakers will be closely watching this dynamic and, more importantly, the path of inflation, between now and the next meeting. If inflation looks to be overshooting the forecast, the Fed may conclude that weak wage growth reflects low productivity rather than slack in the economy. That would be hawkish. Keep an eye on this space. 

While the headline jobs growth numbers disappointed, note that the forward looking indicator temporary help payrolls remains on an uptrend:

In some ways this feels like 1995-96, with a temporary slowdown followed by a sustained period of solid growth. 

The back-to-back declines in retail trade reflected the ongoing stress in that sector:

 Note too slowing wage growth in retail trade:

As of the last JOLTS report, the dynamics in retail trade employment are not driven by layoffs, but by a hiring slowdown:

Looks like both quits and hirings rolled over in recent months. What is interesting is that the due to the labor churn in the sector, a slowdown in hiring alone can have significant impact on the net job growth without relying on mass layoffs - at least not yet. Notice that discharges and layoffs in the sector are down from 2015. Still, the decline in the level of quits reflects employee worries about the state of the industry - they don't see it quite as easy to find a new job as they did in 2015. 

One data point that doesn't seem to fit with the story of an industry in decline is the level of job openings:

If the sector is experiencing a truly apocalyptic event, we would expect job openings to roll over. How will the Fed view this story? Most likely as industry specific and not indicative of the broader economy but they will attempting to gauge the resulting slack, if any, in labor markets. 

Bottom Line: Employment report was in line with (diminished) expectations. Most important for monetary policy was the decline in the unemployment rate. But absent more data, the exact implication could be either dovish or hawkish. Until the fog on that issues clears, expect the Fed to stick to its story: More tightening is coming, but at a gradual pace. 

 

Fed Likely To Discount Weakness in March Employment Report

It seems that we are conditioned for a disappointing jobs report tomorrow. Although the ADP report came in strong, we have mixed signals from the employment components of the ISM reports, with the employment index up in manufacturing but down in the much bigger service sector. In addition, weather may be a factor - did warm weather goose the January and February numbers and now we will see payback due to a cold March? I expect that the Fed will be expecting the latter. The minutes suggest they are already primed for weaker first quarter numbers to begin with:

Participants generally saw the incoming economic information as consistent, overall, with their expectations and indicated that their views about the economic outlook had changed little since the January-February FOMC meeting. Al­though GDP appeared to be expanding relatively slowly in the current quarter, that development seemed primarily to reflect temporary factors, possibly including residual seasonality.

They would probably write off a weak headline payrolls numbers as a reflection of just another temporary factor. Of course, that also means they will embrace a solid number. It's kind of a heads they win, tails you lose situation for the Fed.

Consensus is looking for 175k on the payrolls in a range of 125k to 202k. This sounds reasonable; my estimate is 190k within a wider range of 106k to 275k:

Variance on these estimates, however, is notoriously high. My inclination is to expect the actual print to be more likely below and above 190k.

Assuming a weak read of payrolls that is written off to weather, the rest of the report is more important. The Fed maintains a laser sharp focus on signs unemployment is significantly undershooting the natural rate. Consensus expects the rate to hold at 4.7%. A drop would raise eyebrows at the Fed. An increase in the participation rate, however, would be welcome news that they can maintain a gradual pace of tightening. And wages of course will help guide them as they assess their distance from the natural rate.

Bottom Line: Unless the report is a complete disaster, I would expect the Fed is poised to look though any weakness. But that means a strong report will grab their attention.

 

Lots To Chew On In The FOMC Minutes

The minutes of the March FOMC meeting confirmed that the Fed remains poised to tighten policy further, first via raising the federal funds rate followed by action to reduce the balance sheet later in the year. It appears most likely that the Fed will see the latter as a substitute for the former. That means rate hikes would perhaps be on hold during the start of 2018 as the Fed assesses the efficacy of its actions. To be sure, however, the pace and mix of tightening remain data dependent. With the Fed in general agreement that the economy is near full employment, an uptick in either the pace of growth or inflation concerns will prompt the Fed begin murmuring about an accelerated the pace of tightening.

The Fed tackled balance sheet strategy early in the meeting. On timing, the policymakers thought thought it soon be upon us:

 Provided that the economy continued to perform about as expected, most participants anticipated that gradual increases in the federal funds rate would continue and judged that a change to the Committee's reinvestment policy would likely be appropriate later this year.

Now place that prediction in the context of this discussion from the committee action portion of the minutes:

Members generally noted that the increase in the target range did not reflect changes in their assessments of the economic outlook or the appropriate path of the federal funds rate, adding that the increase was consistent with the gradual pace of removal of accommodation that was anticipated in December, when the Committee last raised the target range.

The median rate projection in March held at a total of three hikes for 2017. The Fed believes that the March rate hike was consistent with the gradual pace of policy removal as anticipated in December. Assume then that the economy continues to stay the course, holding generally in line with the Fed's forecasts. Suppose that means the current pace of tightening holds as well.

A continuation of the current pace of tightening - one action per quarter - would put rate hikes in June and September. At that point, the target range in 1.25-1.5%. That is roughly halfway to the currently anticipated neutral rate. Then the normalization of rate policy would be well underway, and then, in December, the Fed switches gears to balance sheet reduction. Later this year, as stated in the minutes.

That suggests that "gradual" means policy action once a quarter. (Remember the Fed began 2016 thinking four hikes? I think once a quarter seems about right to them.) If so, and they still intend a total of three rates hikes and balance sheet action for 2018, it implies they think, reasonably, that action on balance sheet reduction is a substitute for rate hikes. And, furthermore, that the balance sheet forecast is implicitly built into the median rate forecast. If not for having to deal with the balance sheet, I suspect the median forecast for 2017 would be 4 rate hikes.

That gets you through 2017. What about 2018? They probably have in mind that the phasing out of reinvestments could take six months, though this has not yet been decided. Back to the minutes: 

An approach that phased out reinvestments was seen as reducing the risks of triggering financial market volatility or of potentially sending misleading signals about the Committee's policy intentions while only modestly slowing reductions in the Committee's securities holdings. An approach that ended reinvestments all at once, however, was generally viewed as easier to communicate while allowing for somewhat swifter normalization of the size of the balance sheet.

The Fed could go cold turkey on reinvestments, option 2, but I suspect will choose to ease into balance sheet reduction, option 1. Less chance of disrupting financial markets. That would mean policy action at the second meeting of 2018 to get reinvestment strategy on its final path, followed up quarterly rate hikes after that. 

Assuming this is the schedule they have in mind, policymakers expect to tighten policy once per quarter for the next two years, trading off between rate hikes and balance sheet policy. The risk, however is that balance sheet reduction takes longer than expected, or it more disruptive than expected, thus reducing the scope for rate hikes in 2018. Time will tell on that one.

The Fed, however, could step up the pace of action. On the mandates:

Nearly all participants judged that the U.S. economy was operating at or near maximum employment. In contrast, participants held different views regarding prospects for the attainment of the Committee's inflation goal.

Inflation continues to be the sticking point. If inflationary pressures were more visible, the Fed would be acting more aggressively. Watch this space, and core-PCE inflation in particular. It picked up in January and February. If that continues into March and April, the Fed will worry that they have pushed "gradual" as far as it will go. Watching employment, however, is a bit more tricky. For now, I expect the Fed to get nervous of a significant undershoot if the unemployment rate dips much further. Persistent low inflation, however, could yield a decrease in the Fed's estimate of the natural rate of unemployment. 

Finally, note this:

In their discussion of recent developments in financial markets, participants noted that financial conditions remained accommodative despite the rise in longer-term interest rates in recent months and continued to support the expansion of economic activity. Many participants discussed the implications of the rise in equity prices over the past few months, with several of them citing it as contributing to an easing of financial conditions. A few participants attributed the recent equity price appreciation to expectations for corporate tax cuts or to increased risk tolerance among investors rather than to expectations of stronger economic growth. Some participants viewed equity prices as quite high relative to standard valuation measures. It was observed that prices of other risk assets, such as emerging market stocks, high-yield corporate bonds, and commercial real estate, had also risen significantly in recent months. In contrast, prices of farmland reportedly had edged lower, in part because low commodity prices continued to weigh on farm income. Still, farmland valuations were said to remain quite high as gauged by standard benchmarks such as rent-to-price ratios.

Fed officials aren't growing nervous about just equities. They are seeing high prices across a wide range of risky assets. If it was just one asset class, they might conclude that it doesn't pose systemic risk for the US economy. Or they might conclude that macro prudential policies were sufficient to maintain financial stability. But a wide range of assets might require a more blunt tool - like higher rates. Another space to watch. Where this space gets messy is the tendency of equity prices to remain high even as the Fed tightens - a pattern which may induce the Fed to tighten much more aggressively than they should.

Bottom Line: The Fed clearly anticipates more tightening, likely at a pace of one action per quarter between interest rates and balance sheet. My interpretation of the minutes is that with the economy near full employment and assuming asset prices stay high, it wouldn't take much movement on the labor market or inflation expectations to make Fed officials sufficiently nervous that you begin to hear more about stepping up the pace of tightening.  

The Fed Knows Better...

Federal Reserve officials continue to anticipate additional monetary policy tightening this year on the order of another two interest-rate increases. They have no reason to back down just yet. The weakness seen in “hard” economic data based on actual performance relative to “soft” data, such as surveys, is enough to temper concerns that they are falling behind the curve and keeps a May move off the table. That means they can be patient and adjust their forecasts, if necessary, before the June 14 meeting...

Continued at Bloomberg Prophets...