donderdag 5 juli 2018

FOMC Minutes Show Hawkish Fed Eying "Very Strong Economy"; Fears Tariffs, Yield Curve

Having hiked rates and tilted hawkish in the June FOMC meeting, markets have signaled their displeasure ever since (stocks, yield curve down notably) but The Minutes show no sign of The Fed trying to jawbone that 'displeasure' back as they reassure that "gradual hikes are needed amid a 'very strong' economy." The Fed Minutes also showed member give themselves an 'out' with a warning that "most Fed officials saw intensified risks around trade policy." Not just "some", or a "few", but many. In other words, if Trump ends the economy into a tailspin, he will also prevent the Fed from hiking further. Also of note The Fed highlighted that "a number of Fed officials said it was important to watch the yield curve slope."
# And specifically on the number of rate hikes: "Based on their current assessments, almost all participants expressed the view that it would be appropriate for the Committee to continue its gradual approach to policy firming by raising the target range for the federal funds rate 25 basis points at this meeting. These participants agreed that, even after such an increase in the target range, the stance of monetary policy would remain accommodative, supporting strong labor market conditions and a sustained return to 2 percent inflation." "With regard to the medium-term outlook for monetary policy, participants generally judged that, with the economy already very strong and inflation expected to run at 2 percent on a sustained basis over the medium term, it would likely be appropriate to continue gradually raising the target range for the federal funds rate to a setting that was at or somewhat above their estimates of its longer-run level by 2019 or 2020."
# On trade: "Most participants noted that uncertainty and risks associated with trade policy had intensified and were concerned that such uncertainty and risks eventually could have negative effects on business sentiment and investment spending. Many District contacts expressed concern about the possible adverse effects of tariffs and other proposed trade restrictions, both domestically and abroad, on future investment activity; contacts in some Districts indicated that plans for capital spending had been scaled back or postponed as a result of uncertainty over trade policy."
# On inflation: "In general, participants viewed recent price developments as consistent with their expectation that inflation was on a trajectory to achieve the Committee’s symmetric 2 percent objective on a sustained basis, although a number of participants noted that it was premature to conclude that the Committee had achieved that objective. Although core inflation and the 12-month trimmed mean PCE inflation rate calculated by the Federal Reserve Bank of Dallas remained a little below 2 percent, many participants anticipated that high levels of resource utilization and stable inflation expectations would keep overall inflation near 2 percent over the medium term. Some participants raised the concern that a prolonged period in which the economy operated beyond potential could give rise to heightened inflationary pressures or to financial imbalances that could lead eventually to a significant economic downturn."
# On fiscal policy: "Participants generally continued to see recent fiscal policy changes as supportive of economic growth over the next few years, and a few indicated that fiscal policy posed an upside risk." # On Europe and EM Risks: "Many participants saw potential downside risks to economic growth and inflation associated with political and economic developments in Europe and some EMEs."
# On the yield curve: "A number of participants thought it would be important to continue to monitor the slope of the yield curve, given the historical regularity that an inverted yield curve has indicated an increased risk of recession in the United States." "Participants also discussed a staff presentation of an indicator of the likelihood of recession based on the spread between the current level of the federal funds rate and the expected federal funds rate several quarters ahead derived from futures market prices."
# On the Fed's "accommodative stance": "Participants discussed how the Committee’s communications might evolve over coming meetings if the economy progressed about as anticipated; in particular, a number of them noted that it might soon be appropriate to modify the language in the postmeeting statement indicating that ‘the stance of monetary policy remains accommodative.’"
# On Fed balance sheet shrinkage: "Consistent with the June 2017 addendum to the Policy Normalization Principles and Plans, reinvestment purchases of agency MBS then are projected to fall to zero from that point onward. However, principal payments on agency MBS are sensitive to changes in various factors, particularly long-term interest rates. As a result, agency MBS principal payments could rise above the monthly redemption cap in some future scenarios and thus require MBS reinvestment purchases. In light of this possibility, the deputy manager described plans for the Desk to conduct small value purchases of agency MBS on a regular basis in order to maintain operational readiness."
# And perhaps most importantly, the Fed's discussion of what happens when the Fed's balance sheet shrinks "too much", as the head of the Bank of India discussed recently and warned of an emerging market crisis if the Fed continues shrinking its balance sheet, and how monetary policy can be managed when excess reserves shrink to the point where the market no longer responds to the Fed (as the recent 5bps IOER adjustment showed will happen): "A few participants suggested that the Committee might want to further discuss how it can implement monetary policy most effectively and efficiently when the quantity of reserve balances reaches a level appreciably below that seen recently"
*) The lack of belief in The Fed's dot plot expectations is as wide as we have seen it...

Since The Fed hiked rates in June, the US Treasury yield curve has collapsed (2s30s from around 55bps to below 40bps today), flashing a big red 'policy error' warning sign...

Which may help explain why stocks have performed so poorly (and bonds so well) since the hike...