Fed Minutes Show the Market Needs to Rethink Its Rate-Cut Expectations

The minutes of the Federal Reserve's May meeting were released Wednesday. I can't say anything in the minutes was a surprise, since it mostly just elaborated on what we heard on the day of the release. The big takeaway is that it will take a lot for either the Fed to hike or cut. The minutes suggest the Fed thinks the current stance will be appropriate for some time. It could be that the market needs to rethink its certainty that a rate cut is coming sometime in 2019. Here's my take. You keep using that word. I do not think you know what it means. Stop me if you've heard this one, but the current bout of weak inflation is merely transitory! We already knew this from Chair Jerome Powell's press conference, but the Fed seems unperturbed by Core PCE falling to 1.6%. I've got two problems with this. One is that you can always find individual items within the PCE that are low for temporary reasons. However, the Core PCE has been over 2% just once in the last seven years. That isn't my definition of transitory. My second problem is that by being so dismissive of sliding inflation, the Fed is playing into the notion that they aren't actually going to hew to their inflation target to the downside. This hurts their credibility. Regardless, we can safely say the Fed isn't actively considering cutting right now. The Market vs. the Fed That being said, the bond market is still pricing a 70% chance of a rate cut in 2019. Is that right in light of the Fed's nonchalance about inflation? This is where I'm saying the Fed is risking their credibility. The market is looking past the Fed's words and assuming that they will choose to cut at least once. If they do cut, the whole inflation is transitory thing becomes a cry wolf problem. We'll know we can't trust their words. If they don't cut but inflation stays low, then there won't be any credibility around a symmetric target. That will result in the market's inflation expectations continuing to slide. It also risks the recent surge in stock prices. The Fed needs to follow through on that cut to justify the stock market's rise. If they don't, look out below. What are they actually worried about? The Fed could find some middle ground that would allow them to retain credibility. Just say something like: While we aren't ready to cut rates just yet, if inflation persists meaningfully below 2% we are ready to reduce our funds target. Yet they aren't doing this. They are expressly avoiding talking about rate cuts. Why? One answer might be concerns about the lending markets. While Powell seemed unconcerned in a speech on Monday, the minutes suggest there was a meaningful conversation about corporate leverage and systemic risks. My reading of this section is that while only a few think the leverage increase is an immediate problem, I also suspect many think it poses some kind of risk. This is the conundrum that the Fed faces as it thinks about goosing inflation higher. Whatever they do that helps boost inflation will also encourage risk taking. It is classically the case that the longer a cycle extends, the more leverage builds up in the system. It is certainly the case that the more leverage builds, it could make a future recession more painful. What should the trade-off be between longer expansions vs. less painful recessions? I don't know. But I do know if the Fed doesn't want to cut because it is worried about excessive risk taking, then they need to stop talking about inflation being their primary concern. It is counter-productive. Consider the communications to date. When stocks were weak in January, the Fed was talking about downside risks to inflation. Now that stocks have recovered, suddenly inflation weakness is transitory. If they keep this up, the market will assume the Fed will only actually cut if stocks are weak. In other words, solidify the view that there's a Powell Put. That is going to make the risk-taking problem worse, not better! Positioning I still like being long 5-10 year bonds. I haven't taken any profits. While we're probably at a strong resistance point, if we break through here there could be massive buying from hedge adjustments (the so-called convexity buying). Intermediate term, if the Fed isn't going to hike, the downside of this trade is limited. If we get a recession, there's tons of upside. I'll take a low downside, high upside trade every time.

Fed Minutes Show the Market Needs to Rethink Its Rate-Cut Expectations

When it comes to inflation, the Fed may be risking their credibility.

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