On the surface, it was a flat week for the U.S. indexes, but below the surface small-caps and tech stocks sold off about -1% for the week. The international markets were a mixed bag. Europe and Japan were modestly higher after adjusting for the currency move while the emerging world was down. China and Hong Kong fell -1.1% and -1.6% respectively while Brazil sagged -0.9%.
Bond yields dipped modestly on the week on soft growth and inflation data. The yield on the 10-year fell 4bps and intermediate-term Treasury bonds gained +0.4% for the week. Long-term bonds were up strongly (+1.6%) as the yield curve flattened significantly. As you can see below, the spread between the 10-year and the 2-year yield hit 85bps this week, the lowest level since before the election.
And finally, on Friday Amazon announced that it was buying Whole Foods for $42 a share in an all-cash deal, valuing the company at $13.7 billion (a 27% premium to Thursday’s closing price). Amazon’s stock actually rallied 2.4% on Friday after the deal was announced, adding roughly $11 billion to the company’s market cap. Does that mean Amazon picked up Whole Foods almost for free??
Backdrop for the Fed…
The main event this week was the Fed meeting on Tuesday and Wednesday. It’s wasn’t so much uncertainty about a rate hike (a move was widely expected), but more what the Fed would say about the recent soft growth and (especially) inflation numbers of late. For example, retail sales came in below expectations this week. Sales decreased -0.3% in May month-over-month. Year-over-year sales are up +3.8% as you can see below, so it isn’t like sales are plummeting. But recent performance has been underwhelming.
Along the same lines, inflation is proving to be very stubborn. The big bet at the beginning of the year was that inflation would tick higher as low unemployment fed through into more rapid wage growth and increased pricing pressure. Well, this simply isn’t happening yet. For example, the Consumer Price Index (CPI) rose 0.2% in May while the seasonally adjusted CPI actually fell 0.1% in May. If you strip out food and energy inflation increased just 0.1%.
The chart below shows the year-over-year changes in four measures of inflation. Obviously, none of those lines are pointing higher.
Another way to look at this is shown below. This chart shows both year-over-year changes in core inflation and the 3-month annualized rate. This tells us that prices haven’t moved in the last three months.
So, the Fed has something of a dilemma. They have been tightening rates the last few months in part to head off future inflation. But future inflation isn’t showing up. You could actually make the case that future inflation is turning into future deflation.
…But They Stick to the Script
With this as the backdrop to the Fed meeting, most thought we’d see a rate hike regardless. After all, the Fed has been very vocal the last few weeks in signaling a rate hike. Sure enough, the Fed increased the Fed Funds target rate to between 1% and 1.25%. Other key points:
- The famous dot plot didn’t change much. It still points towards a total of three hikes this year and another three hikes next year. The chart below shows the median forecast for the Fed Funds rate over the next few years. Not much changed at this meeting.
- However, dig into the details a little bit and it gets pretty entertaining. The chart below shows each participant’s estimate for the Fed Funds rate. This year 8 participants see one more hike, four see two more hikes, and 1 thinks we see none. I guess you could call this a consensus, but it’s close. Looking further out opinions diverge. For example, one member sees the Fed Funds rate at over 4% in 2019. Another sees it at 1%. You have to love the dismal ‘science’!!
- The statement that goes along with the meeting was modestly more upbeat on the growth outlook, noting the continued decline in the unemployment rate. GDP growth in 2017 was upgraded a tenth to 2.2%, and the path for the unemployment rate was lowered significantly to 4.3% this year and 4.2% in 2018-2019
- They did acknowledge the decline in inflation, but the statement continued to note that core inflation is running only “somewhat” below 2%. This was a more hawkish reference than many expected. The Feds expectation for core inflation for this year was lowered to 1.7% but was unchanged at 2.0% for next year.
Balance Sheet Shrinkage
A new wrinkle in the ointment regarding the Fed is their new plan to shrink the size of their balance sheet. If you cast your mind back a few years ago all we talked about was Quantitative Easing (QE). This entailed the Fed buying bucket loads of bonds from the banks and putting these bonds on the Fed’s balance sheet. It was a way of injecting reserves into the banking system to (hopefully) spur lending, lower interest rates, and juice the economy. Whether this worked or not is still being debated, but the Fed’s balance sheet grew from roughly $800 billion before QE to $4.5 trillion when all is said and done (see below). They bought a lot of bonds!!
In the interest of getting back to normal the Fed now wants to shrink their mammoth holdings by not reinvesting maturing bonds. They are going to start slow. To begin with they will allow $6 billion per month of Treasury bonds to mature and another $4 billion of mortgages. This will increase every quarter to a maximum of $30 billion and $20 billion respectively.
As we said, this will be slow. The chart from Capital Economics shows how the balance sheet will shrink under the current plan. By 2021 roughly $2 trillion of bonds will have matured – not quite half today’s amount.
What does this mean for the markets and the economy? No one is quite sure.
- Everything else equal it should push interest rates up by some amount, but few are sure by how much.
- QE is only one factor that drives rates. Growth and inflation expectations also play a key role, as does foreign demand.
- With Japan’s 10-year bonds yielding zero and Germany’s just +0.28%, today’s +2.16% Treasury yields looks pretty juicy.
- Furthermore, the increase in bond supply due to balance sheet tapering is unlikely to swamp the market any time soon. The chart from BCA below shows the bonds coming to market in 2018 assuming the Fed goes ahead with their new plan. Certainly the supply of bonds that the private sector needs to absorb increases, but it isn’t by much, particularly in a global context.
Will the Fed Capitulate in 2019?
In our mind, balance sheet tapering is a marginal change. It isn’t something that is going to push rates dramatically higher any time soon, particularly now the market has had a chance to digest the news. What’s more interesting is the Fed’s plan to increase rates three more times in 2018. If you look at inflation expectations in the chart below, at today’s levels the Fed has historically been ramping up stimulus, now taking the punch bowl away (the chart below shows inflation expectations for a five-year period, starting five years from now).
As John Authers noted in the FT on Friday:
“But this week, the outline of an old conflict has grown clear once more. The bond market is again battling central banks. And deflationists — who believe that the western world is stuck in low growth and low or negative inflation — have resumed with vigour a battle they appeared to have lost to the reflationists, who believe that the world is at last emerging from the morass.”
Three hikes in 2018 stands a good chance of slowing growth and pushing inflation expectations even lower. This would probably invert the yield curve and get us all talking about recession. But we’ve seen this movie before where the Fed says one thing only to pull a Lucy and snatch the ball away at the last minute. At what point will the Fed capitulate this cycle?
Have a good weekend.
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