I have talked a decent bit about the jobs report in my last two posts here. So I want to say more about what the information in that report says to Fed members, given recent Fed guidance and speeches. I am going to lean heavily on comments by Lael Brainard as she is the policy dove whose more hawkish comments tell you how the central tendency of thought is shifting at the Fed.
First, let’s get the lead-up right. The Yellen Fed took us off zero in 2015, promising a data-dependent policy path as it raised rates for the first time in nearly a decade. And indeed, the Fed was true to its word. Despite calling for a multi-hike 2016, the Fed stood pat until December 2016 before raising rates again.
In 2017, the Fed also moved to tighten via the balance sheet, a message Jerome Powell delivered. And this quantitative tightening lever allowed the Fed to continue to tighten in the second half of 2017, while standing pat on hikes and testing the waters on balance sheet reduction.
As Jerome Powell took over in 2018, the consensus view inside the Fed was that angst about the job market that accompanied the Yellen hikes was not a big concern. Brainard was key in marking the shift to a policy bias where bad data wouldn’t necessarily mean a pause, neutral incoming data meant continuing along the same path, and positive data meant more tightening. Under Yellen, weak and neutral data had induced policy pauses.
So, as the unemployment rate declines well below the Fed’s long-term target level, the tightening bias means data have to be very bad to induce a pause. Timetable acceleration is the more likely option, especially in circumstances where the data are good, as they were today.
That’s the setup here.
Now look at what Brainard was saying just yesterday. I have highlighted the important bits:
Growing above Trend
Although indicators of economic activity were on the soft side earlier in the year, the outlook for the remainder of 2018 remains quite positive, supported by sizable fiscal stimulus as well as still-accommodative financial conditions.[…]
I expect real GDP growth to pick up in the next few quarters. In particular, the fundamentals for consumer spending are favorable: Income gains have been strong, consumer confidence remains solid, and employment prospects remain bright. And business investment should remain solid, with drilling and mining bolstered by increased oil prices.
Moreover, the sizable fiscal stimulus that is in train is likely to provide a tailwind to growth in the second half of the year and beyond. From a position of full employment, the economy will likely receive a substantial boost from $1.5 trillion in personal and corporate tax cuts and a $300 billion increase in federal spending, with estimates suggesting a boost to the growth rate of real GDP of about 3/4 percent this year and next.
That’s pretty darn hawkish. And while Brainard went on to mention some risks, don’t be fooled by that; her base case is the one presented above. She’s bullish on the US economy.
Put her comments into the jobs report context. From a policy perspective, the Fed is behind the curve since they have showed no concern about inflation and are predicting year-end 2018 unemployment at 3.8%, which we just reached.
So the Fed has two options. First, it could watch the data over the course of the year and add a fourth rate hike to its previously communicated three. That doesn’t have to involve an immediate guidance toward a fourth hike. It could just wait and see. But, obviously, if the unemployment rate dips further, markets will frontrun any lack of guidance.
The Fed could also increase its quantitative tightening regime. The fact that the Fed minutes show that the Fed has had to adjust its interest on excess reserves protocol is an embarrassing admission. To me, it suggests the Fed may want to roll off its balance sheet more aggressively in order to reduce the amount of excess reserves in the system. Doing so would give them a way of administering an extra tightening without explicitly raising rates.
And tightening without raising rates is something the Fed is interested in. Last year, St. Louis Fed President Bullard was the first Fed official to openly question whether raising rates too quickly could flatten the yield curve, signalling excessive tightening and potential economic weakness. As yield differentials between 2- and 10-year bonds have sunk below 50 basis points, the worry in the market has increased significantly. Brainard addressed this, but in a rather hawkish way. Note the part I have bolded in her comments below.
The Yield Curve
Even though longer-term Treasury yields have moved up, on net, since the beginning of the year, there has been growing attention of late to the possibility of an inversion of the yield curve–that is, circumstances in which short-term interest rates exceed long-term interest rates on Treasury securities. Historically, yield curve inversions have had a reliable track record of predicting recessions in the United States. Since 1960, the 3-month Treasury yield has moved above the 10-year Treasury yield before every recession except the one in 1990, and, conversely, there has only been one case where the yield curve has inverted and a recession has not followed–in 1966.[…]
As we try to assess the implications of this flattening of the yield curve, it is important to take into account the very low level of the current 10-year yield by historical standards.
Other things being equal, a smaller term premium will make the yield curve flatter by lowering the long end of the curve. With the term premium today very low by historical standards, this may temper somewhat the conclusions that we can draw from a pattern that we have seen historically in periods with a higher term premium. With a very low term premium, any given amount of monetary policy tightening will lead to an inversion sooner so that even a modest tightening that might not have led to an inversion in the past could do so today.
[…]
…So while I will keep a close watch on the yield curve as an important signal on how tight financial conditions are becoming, I consider it as just one among several important indicators. Yield curve movements will need to be interpreted within the broader context of financial conditions and the outlook and will be one of many considerations informing my assessment of appropriate policy.
What she’s saying is that she cares about the yield curve but that it may not be a reliable signal. She’s downplaying the curve. That’s a hawkish message.
Branard is telling you fairly explicitly that the Fed doesn’t consider inversion prima facie evidence of overtightening. Even if the curve were to invert, it may well be that other economic indicators say just the opposite.
This is dangerous stuff, folks. My view here is that while the US economy is strong today, we are likely very near the end of this cycle. And the curve’s flattening is a good sign that the Fed’s policy stance is moving into the realm of overtightening. Below 50 basis points between the 2- and 10-year bond yields is the indicator I am looking for.
As I have said previously, I expect 10-year yields to be anchored around the 3% level but for 2-year yields to move up, with most of the curve flattening that results coming as a result of higher short rates rather than lower long rates. Nothing Brainard said or that the jobs report shows dissuades me from that view.
And let’s remember that Fed policy acts with a lag. When the curve inverts, there will be no corroboration from the real economy. The reason a curve inversion is a bad signal is because, if you ignore it, by the time you pay attention because of negative incoming economic data, it will be too late. The die will be cast and the data will continue to deteriorate.
In the medium-term, then, expect the Fed to be more hawkish than ever. The unemployment rate is simply too low for them not to maintain or accelerate their tightening path. That is a recipe for rising yields. And I don’t expect Fed policy to transmit though to an increase on the long end. And so the yield curve will flatten to within a whisker of inversion.
By the end of the year, the real economy will still look good enough on the outside to be supportive of equities and of other risk assets like high yield. But the seeds of end of cycle dynamics will be building for 2019. My base case is for inversion to happen in Q4 2018 or Q1 2019 and for the recession to occur near the end of 2019 or in 2020.
2019 is the year when asset prices will feel the impact of this change.