Written by Bruce J. Clark
March 17, 2019
Until recently the Fed had been generally dismissive of the trend toward a flatter yield curve and the negative implications it carried for the trajectory of inflation and the economy, choosing instead to trust that the rising tide of a robust labor market would push prices higher and continue to justify the steady march toward policy normalization from post-recession extremes.
But this week a red flag appeared in the market that will be hard for the board to ignore. The benchmark 2yr treasury yield fell below the Fed’s main policy rate, a sure sign that despite official forecasts the peak of the current rate path is rapidly approaching, if not having already passed. Economic cycles have unknowable but finite lifespans. Even though the current
expansion that began in June 2009 is only a few months from being the longest in history, the inversion in rates suggests the possibility that the old record may be safe.
At the upcoming March 19-20 policy meeting the Fed will be forced to address the large and growing gap between their own projections and the outcome being embraced by the short-term rate complex. The Summary of Economic Projections (SEP) last updated in December foresaw two rate hikes in 2019 and one more in 2020, ultimately putting the current Fed Funds rate of 2.40% at around 3.125%. The problem for chairman Powell is that over that same time period the market is not only not pricing in rate hikes but an easing instead, discounting a lower year-end 2020 overnight rate of 2.15%.
Having learned from the experience of the bond market massacre in 1994 triggered by a surprise hike in rates the Fed has not since tightened unless the futures market has priced in at least a 70% chance of it happening https://bit.ly/1Khc3xm. Seeing that market-based odds for any further rate hikes over the next couple of years is essentially zero the economy would have to rebound sharply to put any further tightening into play. It’s not impossible but a highly unlikely scenario at this late stage in the expansion.
Reconciling the difference with the marketplace is a tricky proposition for the Fed. The market is clearly pushing them to ease but without more evidence of economic weakness they are reluctant to abruptly reverse course and jeopardize their credibility by perhaps being too reactive to the normal ups and downs in growth. In addition to that they risk being seen under the thumb of the president Trump, who late last year criticized current policy and chastised them for not having a good feel for the economy and markets https://nyti.ms/2T936Bh.
The lesson of 2018 is that in an increasingly inter-connected global economy, policies of the major central banks can diverge for only so long before something snaps, and the convulsions in the equity markets late in the year were a sign that a breaking point had been reached. Rising rates and an accompanying strong dollar exposed many corporate and sovereign entities to the perils of having leveraged themselves with cheap USD funding under quantitative easing.
Ongoing geopolitical and trade uncertainties now require the Fed to be a force for stability, not a source of volatility. A backstop for global economic weakness. While the board won’t fully embrace easier policy next week they will take the market’s lead and begin making baby steps in that direction. Investors should take this as further evidence that a top in rates and the dollar is in place and that any talk of higher rates is just that…..talk.