It was all about the Federal Reserve this week and what they might do with policy in the months to come. Of course, they don’t know what they are going to do anymore than the rest of us, but they are compelled to make forecasts given the business they are in, and the markets respond accordingly.
The main takeaway from Wednesday’s announcement was that the Fed thinks it may raise rates twice in 2023. Back in March they projected no hikes until 2024. This is based on the Fed’s so called dot plot that shows where all the committee members think rates will be in the coming years. As you can see below, seven officials see a hike by the end of next year, but on average rates don’t change until 2023.
While the hike narrative got all the attention, it is notable that no one at the Fed sees a rate hike in 2021 despite two straight months of scorching-hot inflation. And the whole dot plot thing is sorta weird anyhow. During Chairman Powell’s testimony he made the following quote regarding the two hikes in 2023 – “We didn’t actually have a discussion about that…The dots are not actually a great forecast.”
He also said at another point that “The dots need to be taken with a great grain of salt.”
This is just too good. The markets react to a graph that the Fed itself isn’t too keen on. The market put odds of hike by the end of 2022 at over 90% post Fed meeting.
But this is based on a dot plot that most people at the Fed don’t seem to like. Is the Fed too afraid to get rid of a clumsy tool of its own creation? Humans are weird sometimes!!
But the meeting was considered a hawkish surprise – hawkish meaning a Fed inclined to reduce stimulus (be it higher rates or less asset purchases). Chairman Powell acknowledged the committee talked about tapering their asset purchases at the meeting, not a complete surprise. The general view is this could start early next year. Goldman’s view is pretty standard:
‘We continue to expect the first hint about tapering in August or September, followed by a formal announcement in December that would begin the tapering process at the start of next year, though the risks lean toward an earlier start.’
Stocks and commodities sold off on the news, which also isn’t really surprising. More surprising was the reaction of the bond market. Yields fell across the board, with the 10-year pushing to multi-week lows as you can see below.
Outside of government bonds, yields on Junk Debt hit another all-time low this week of 3.84%.
Outside the U.S., the yield on Greece’s five-year bond fell below zero briefly this week. Of course, this means that investors are in effect prepared to pay Athens to borrow for up to half a decade, despite debt levels that have soared to more than 200 per cent of GDP during the pandemic. Oh, yea, and Greece periodically defaults. But yields are lower there than in the U.S.? Again, humans can be weird sometimes!!
What gives? Probably a couple things.
First, a hawkish Fed means they are unlikely to be asleep at the wheel on the inflation question, or at least that is the view at the moment. Inflation is likely to be transitory not only because of the issues we have talked about the last few weeks, but also because the Fed will make it transitory through policy moves.
The second factor is maybe more subtle. The Fed is getting hawkish at what appears to be the peak in the growth and inflation cycle. So, any tightening is likely to exacerbate any growth slowdown in the quarters to come. For example, the surprise index shown below measures the number of economic releases in the U.S. that are beating expectations. It’s the first hint the growth rate could be hitting a peak this quarter.
And the pressure from commodity prices on input prices is rolling over. Lumber has taken it on the chin.
As has copper.
Neither mean deflation is returning, only that we may be at the point of maximum inflation worries and things will moderate in the months to come.
Finally, any talk of tapering bond purchases will bring back the deflation chatter. Yields have tended to go up during periods of quantitative easing, as you can see below.
Time will tell how serious the Fed is and how much growth and inflation slows in the next few months. But we suspect if growth starts to moderate Powell will start to walk back the idea of a rate hike in 2022.
Charts We Found Interesting
1. Time to reopen our northern border given the dramatic fall in case counts? But maybe the Canadians are enjoying the peace and quiet?
2. In general vacation rates are closing in on half the eligible population. But there are still a number of counties below 25%.
3. The above chart is worrisome given the rising case count in the UK due to the Delta variant.
4. In case you were wondering how have asset classes performed during periods when the Fed is hiking interest rates.
5. Predictions are hard, especially about the future.
6. The inequality problem in one chart. Are the lines going to meet again in five-to-ten years?
7. The Drought Monitor as of May 31st.
8. This is mesmerizing. The topography of the Roman Empire at its largest in AD 117.
9. This feels about right.
Have a good weekend.
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