It is a big day for the U.S. Federal Reserve. We got a rate hike, a guidance on balance sheet management and an updated economic forecast. Here are my takeaways.
Fed Hikes Target Rate
The Fed took its target interest rate range up to 1% to 1.25%. This was widely expected and heavily telegraphed by Fed officials, so no surprise here. But it is worth noting that the Fed chose to hike despite some weaker economic data recently. Core PCE (the Fed's favored inflation measure) came in at just 1.5% year over year, according to the most recent estimate. The Fed can't credibly claim that is "close" to its 2% target.
The consumer price index (CPI) was reported today, and the core measure was at 1.7% year over year, which is down from 1.9% last month and 2.3% just four months ago. Meanwhile, the employment picture is mixed at best. Non-farm payroll gains seem to be slowing and, as I wrote right after the jobs report, seem to be threatening to fall into stall-speed territory.
All of this softness could easily be transitory. I am watching closely, but not panicking. But it is notable that the Fed is willing to look past this weakness. A year ago at this time, the Fed was willing to use any excuse not to hike. Now the burden of proof seems to have shifted -- i.e., it wants to hike and needs to be convinced otherwise.
Economic Outlook Upgraded Despite Weaker Hard Data
Indeed, the Fed seems convinced that this spate of mediocre data is temporary. In the Summary of Economic Projections, the Fed actually upgraded its GDP forecast for 2017. So what gives the Fed such confidence that the current weaker data aren't a nascent trend? In part, it's that business survey data show a lot of confidence. The Non-Manufacturing ISM Employment survey was at 57.8, which for context is the second-highest read since the recession and the fifth-highest ever. In addition, the Job Openings and Labor Turnover Survey (JOLTS) shows a record number of job openings, suggesting demand for labor is high, which could very well turn into higher wages in the near term.
The so-called dot plot emphasizes this point as well. The Fed hasn't changed on median in 2017 or 2018.
Hence, the Fed is a bit more worried that it is falling behind the curve and is in fact too loose with policy versus fearing that it might be tightening too much too fast.
The Fed Is Anxious to Get Moving on the Balance Sheet
This is part of why it is anxious about reducing the size of the balance sheet. It could hike in September and stop reinvestment in December or vice versa. Overall, I don't think this matters much.
Regardless, this shows a Fed more worried about moving, however cautiously, toward a more neutral stance. Clearly, the main concern remains that the economy could overheat.
The Bond Market Disagrees
Its lack of immediate reaction to the Fed's release notwithstanding, the bond market has been cutting expectations for rate hikes in 2018 for a while. We can see this by looking at eurodollar futures contracts, which are essentially a way to bet on future LIBOR rates (they are more liquid than fed funds futures for longer-term dates). Today, three-month LIBOR is 1.24%, equal to the high end of the Fed's rate target. The December 2018 contract is trading at an equivalent to LIBOR being 1.7% at the end of 2018, or roughly two more rate hikes for the remainder of 2017 and 2018. In mid-March, this same contract was suggesting 2.2% at the end of 2018. In other words, in the last three months, the market has eliminated two rate hikes over the next 18 months.
You can also see this in how the curve has flattened. The gap between the two-year Treasury and 10-year Treasury has fallen to 79 basis points, down from 135 in December. Don't overread this. You'll hear people say a flatter curve is a sign the economy is slowing. Not really. The curve almost always flattens during a Fed hiking cycle. But the way the curve is flattening right now, with 10-year rates falling outright, it suggests the market thinks the Fed's terminal rate is lower than previously assumed; i.e., the bond market isn't saying the Fed is going to hike slower, it is saying the Fed isn't going to hike as much, period.
Conclusions and Trades
The only way this trend reverses is if inflation picks back up or employment growth accelerates in a serious way. The Fed will probably do another hike regardless, probably in December, taking a pause in September to implement the slower reinvestments. That gives us six more months to assess whether this weakness is temporary.
If it doesn't, then the last hike in 2017 might be the last hike of this cycle period.