Every year we all look forward to certain events to close out the summer. Labor Day cookouts. Start of the NFL season. Back to school shopping. But if you are an economics nerd like me, you look forward to the Kansas City Fed's annual Economic Symposium held in Jackson Hole, Wyoming.
For the most part, Jackson Hole is a premier academic conference, filled with panel discussions and paper presentations. In some cases however, these seemingly ivory tower conversations have had major influence on central bank policy. Michael Woodford's 2012 presentation was a watershed in post-crisis central banking. People who understood quickly how influential that would be would have made a lot of money.
The conference also usually attracts some major speeches from central bankers themselves. Ben Bernanke famously made the case for QE2 in 2010, turning a hotly debated possibility into a certainty, and later made similar cases for QE3. Janet Yellen and Mario Draghi have also used the occasion to make the case for major policy moves.
Unfortunately, the agenda and speaker list are not published until the week of the conference. We know Fed Chair Jerome Powell will be speaking on Friday on "Monetary Policy in a Changing Economy" and that obviously has the potential for fireworks. Here is what I will be looking for in that speech as well as a few other big picture issues that could come up during the conference.
Steady as she goes
I've said before that Powell probably feels like doing a victory lap. Inflation is right at 2%, unemployment keeps falling, financial markets are strong but not ebullient. What more could a central banker ask for? I'm sure he will begin his speech with a little basking in the sun over how its been going.
However I expect him to come with a message: steady as she goes. The market seems convinced that the Fed actually only has 2 maybe 3 hikes left in it before an extended pause. July 2019 fed funds futures contracts suggest the Fed's target rate will be 2.56% approximately a year from now, which is almost 3 hikes from today. The contract structure then goes dead flat from there, suggesting the Fed neither hikes nor cuts as far as the eye can see.
It seems the market thinks that once the Fed gets to its "neutral" rate it will stop hiking. I don't think that's how Powell & co. are actually thinking. The so-called neutral rate is a crucially important concept but totally observable. It is whatever rate results in monetary policy being neither accomodative nor restrictive. We don't know what that rate is until we observe whether any given rate is resulting in a stronger or weaker economy. In other words, the Fed might want to be at neutral, but it also doesn't know what neutral is. All it can do is keep hiking until it seems the economy is slowing.
Powell probably wants the market to be a little less sure of itself, and will thus likely strike a hawkish tone. While he will leave himself enough wiggle room to either accelerate or decelerate rate hikes in the future, I think he wants the market to be prepared for more hikes than it is currently pricing. How will he do this? I'm not sure, but the message will be more or less that as long as unemployment is falling the Fed is probably hiking.
Trades around a hawkish Fed
I took half of my long USD position off this week after we got to an overbought position, but I'll look to reload before Friday. A hawkish Fed is USD positive.
I also like being short 5-year Treasuries. I'm pairing that with a long long-term bond position, but if you want to trade Friday specifically, I'd be outright short intermediate-term bonds. There aren't great leveraged ETFs that fit this area, but there are options on iShares 3-7 Year Treasury Bond ETF ( IEI) . I'm using futures to express this trade.
What could stand in Powell's way?
Interestingly, the very things that could stop the Fed from continuing to hike well into 2020 are probably the kinds of things that will get heavy discussion during the rest of the conference. Space does not permit a full treatment of all these issues, but for those that want to follow the conference more in-depth here are some things to watch for. Again, the speaker list is not known, so these are just some items I expect will get play during the conference.
Declining term premium, cyclical or secular?
The term premium is what investors demand in yield to own longer-term bonds irrespective of their forward view of interest rates. I.e., if the Fed were sitting at a 2% rate target and everyone expected that to stay the same for a long time, you might still demand a little more to own a 10-year bond vs. a 2-year bond just for the uncertainty. Whatever that amount, that's called the term premium. The term premium (which has to be estimated and therefore you see various figures claiming to be right) is currently either near zero or maybe even slightly negative. This is important because if it persists at about zero, there's no reason to expect interest rates to rise much at all. If the near zero term premium is merely temporary (perhaps because of QE programs), then there is much more room for rates to rise.
My sense is that the term premium is so low because inflation expectations are much more stable and the Fed is much more transparent. Hence I don't need as much premium to buy long bonds. And therefore long bonds are a pretty good bet.
Is the Phillips Curve dead?
This is hotly debated but a central concept for the Fed. The Phillips Curve is the idea that as unemployment declines inflation rises. The relationship is logical, but has been hard to find in the data during the last 30 years or so. The idea that we could get a Phillips-style effect is a central reason why the Fed is likely to keep hiking as long as unemployment is falling. It may be that the Phillips curve is real, but not relevant unless unemployment gets very low.
What about a curve inversion?
Some Fed officials have expressed concern that a curve inversion is a sign that the Fed has hiked too far. This could get discussion on its own or be wrapped up in the conversation about the term premium. Afterall, if the term premium has fallen, then a curve inversion isn't quite as meaningful as it used to be. Or so the argument goes. I personally think that a flatter curve means that money is getting tighter. I'll concede that money isn't automatically tight at any given level, but I think we ignore the yield curve at out peril. This time isn't different.
What will we do in the next recession?
I definitely expect some discussion of what central banks can do when we hit the zero bound next. This isn't immediately relevant for people trading today, but is hugely important to understand for the next time the economy slows. Will we do QE again? Will we try negative rates? My bet on both is "no." Various ideas have been floated, and this could be a moment similar to Woodford in 2012, where a proposal made at Jackson Hole becomes the baseline for debate going forward.
-- This article was originally published on Aug. 18
