On Wednesday, the Federal Reserve will conclude their June meeting. There will be a lot for investors to digest: a probable rate hike, a new set of economic projections and a press conference by Chair Jay Powell. With signs of tighter labor markets and a rebound in inflation, this meeting will be closely watched for signs of where the Fed is heading in the coming quarters.
Here are my thoughts on what may happen and positioning around it.
Rate Hike Is a Given
The market has completely priced in a rate hike at this meeting. Going forward it is at about 75% that there will be another hike in September and about 50/50 that there will be a third one in December. However, from there it trails off substantially, with a fourth hike sort of meekly priced in for some time in 2019.
So, as I'm looking at all the data points coming out of the FOMC meeting, I'm not really worried about what it means for September. In my view, the only way a September hike gets derailed is if some real disaster happens between here and there.
I'm thinking more intermediate-term and thus much more focused on what it means for the Fed's reaction function. That is to say, what data could come that would cause the Fed to hike again in December? Or hike more than four more times in this cycle? Or for that matter, what causes the Fed to halt here?
With this meeting the Fed will release a new Summary of Economic Projections (SEP), which includes the infamous "dot plot." This chart represents each FOMC member's view of where the Fed's rate target should be assuming that the particular member's economic forecast comes to fruition.
At times this plot is given more credence than it deserves, but it is very useful in one regard: it is a strong indication of individual members' reaction functions.
Here's what I mean. Lately inflation indicators have been moving a bit higher, more or less in line with the Fed's previous expectations, but still we know the Fed is paying attention. If this trend continues, would the Fed hike more aggressively? The dot plot can be a good indicator of that.
Other parts of the SEP are also worth analyzing. Unfortunately, they are usually ignored by the media. Anyway, one of the most important questions for the Fed today is whether they would let inflation run above their 2% target without reacting with faster rate hikes. And if so, how long would they let this happen? The Core PCE projection in the SEP could give us a clue. In March, the median Core PCE projection was 2.1% for both 2019 and 2020. If either number came in higher it would be very telling.
Press Conference: Listen for Nascent inflation, Curve Shape
For Powell's press conference, I think there are two key things to listen for. First is how he views the rebound in inflation. My personal base case is that inflation has mainly rebounded because some transitory issues holding it down in 2017 are rolling off. This means that the acceleration is real, but that is isn't a given that inflation will keep accelerating.
Is that how Powell views it?
It's more likely that he views this as one possibility. Another possibility is that we get a Phillips Curve-style effect from very low unemployment. When he's asked about inflation during the press conference, I'd expect him to give an answer along these lines.
What's more interesting, and what he won't say explicitly, is what he would do if unemployment drops to 3.5% and Core PCE is at 2.2% by year-end. Will he definitely hike in December plus two more in the first half of 2019? That would be a good bit more than what's priced in now. His exact words in response to inflation questions could give us a good clue.
Is he emphasizing Phillips Curve effects? Is he talking about containing the risks of an overheating economy? Or does he act unconcerned about the whole thing?
What About the Yield Curve?
The other big question is the yield curve. The Fed seems to be talking out of both sides of its mouth lately, saying that they can keep hiking but avoid a yield curve inversion. I will be listening for how the Chair views this issue.
Would the Fed slow down hikes solely because the curve is near inversion? Would that in and of itself be reason enough? Historically it hasn't.
The Fed has hiked until they felt economic risks were balanced between employment and inflation, and by the time they got there the curve was often inverted. If they stick with this historical view, the curve will probably invert sometime in the next six to nine months. If they think keeping the curve positively sloped is a goal in and of itself, they will have to stop hiking in 2018.
Investment Conclusions1. TIPS are a bad play. TIPS yields five years and longer are all overvalued. They are pricing in inflation above 2% on average over the whole period, which would basically necessitate the Fed either letting inflation get well above 2% near-term or else we never hit a recession again. I don't think either is going to happen.
2. Long-term rates are still pretty high. I've been net long interest-rate risk for a while, and it hasn't paid off meaningfully. However, I think the fundamental value is good, and you get paid while you wait. Rates could crash lower over the next year or so if either the Fed stops hiking or signs of economic slowness arise.
3. Short-term municipals are probably the most overvalued part of the entire bond market. Here is an example of something that is truly stupid going on out there. Money has been absolutely flooding into short-term muni funds. This has resulted in an insane valuation gap between short municipals and short taxable bonds. For example, a 2-year AAA muni probably yields around 1.65%, about 90 basis points below 2-year Treasuries. Normally munis have between 85-95% of the yield of Treasuries; this is only about 68%. Or put another way, the yield gap between 2-10 year munis today is about 100 bps. In Treasuries it is only 40 bps. Now you can't reasonably short munis and expect to make a killing. But you are getting paid quite a bit to take on interest-rate risk in municipals. If you haven't been taking my advice to go a bit longer in bonds, and you are a tax payer, now would be a good time to go longer in municipals.
Tom Graff is a regular contributor to Real Money Pro, our premium site for active traders and Wall Street professionals. Click here to get great columns like every trading day.