Macro Wrap-Up

Cut It Out

Topics - Macroeconomics

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Cut It Out

Last week’s Fed meeting came and went with little fanfare. There was an initial flurry of news on the rate cut and the Powell press conference. The stock market reacted with a brief sell-off which quickly reversed. Even the President’s tirade against Fed Chair Jerome Powell seemed routine, like he was just going through the motions. Saying “People are VERY disappointed” is mild criticism by the standards we’ve become accustomed to. 1 1 Close If he really cared, he would be blaming the Fed for mosquitos and the traffic on I-95. (I got to work late today, and I need a scapegoat.) , 2 2 Close Bloomberg: “Trump Claims Americans ‘Very Disappointed’ in Powell and Fed,” 10/31/19. Perhaps the reason it passed so quickly from the public imagination was that Powell and the Fed have put together a clear message for the economy and investors. But if you look closely, the Fed meeting did have a subtle but meaningful effect on markets, and the message is more nuanced than it appears.

With the latest move, the Fed has cut interest rates three times this year. The Fed’s reasoning hasn’t always been easy to follow. The Fed hiked rates in December, but then paused to evaluate the effects. This so-called “dovish hike” vexed investors and may have exacerbated last year’s sell-off in equities. Just six months later, the Fed had reversed course and was seriously considering cutting rates. In the June statement, the Fed expressed concern about “uncertainties and muted inflation pressures,” but deferred easing policy because the members wanted to see more weakness in the data to confirm the view. 3 3 Close Federal Reserve: “FOMC Statement,” 6/19/19. In the interim, between that meeting and the next, economic data releases improved, but the Fed decided to follow its dual mandate of fostering stable prices and sustainable confusion among investors and cut anyway in July. The Fed followed it up with another cut in September and another last week.

Through the summer and into the fall, Fed members’ rhetoric has become more consistent and more coherent. All of the elements of their message were there before the start of the rate cuts, they’re just better articulated now. The first part of this message is that three rate cuts are a “mid-cycle adjustment” rather than a full-fledged cutting cycle. 4 4 Close For example, Charles Evans, President of the Federal Reserve Bank of Chicago gave a speech titled, “On Mid-Cycle Adjustments,” to elaborate on the Fed’s easing. Source: Federal Reserve Bank of Chicago, President Charles Evans: “On Mid-Cycle Adjustments,” 10/1/19. The cuts mitigate risks from the trade war and other external threats to the economy, and the Fed has the luxury to do so because inflation has been under its 2% target. There is no reason to bring rates all the way to zero because the economic situation does not warrant such action. In fact, the Fed thinks the economy is in a “good place” as Vice Chair Richard Clarida said, and recession is unlikely. 5 5 Close They probably don’t mean the same good place in the show with Kristen Bell and Ted Danson. I haven’t watched any episodes, but I hear the place is not in fact so good. , 6 6 Close Federal Reserve, Vice Chair Richard Clarida: “The United States, Japan, and the Global Economy,” 11/1/19. Policy is now neutral or maybe a little accommodative. It’s “appropriate,” so there is no need for further action in the near term. 7 7 Close Vice Chair Richard Clarida recently stated: “We see the current stance of monetary policy as likely to remain appropriate as long as incoming information about the economy remains broadly consistent with our outlook of moderate economic growth, a strong labor market, and inflation near our symmetric 2 percent objective.” Source: Federal Reserve, Vice Chair Richard Clarida: “The United States, Japan, and the Global Economy,” 11/1/19.

It’s almost as if the Fed hired a publicist to write its statements. 8 8 Close A publicist who has a degree in boring and technical communications. If we think about what they’re saying, it’s that they’ve done a good job in managing the economy despite threats from all around. They have “offset trade uncertainty,” as San Francisco Fed President Mary Daly said this week. 9 9 Close Bloomberg. The expansion has been going for ten years, the longest in the U.S. in recorded economic history, and the Fed still thinks we’re somewhere “midcycle.” That’s very optimistic, certainly compared to the gloomy forecasts we’ve seen from a few private sector economists.

The Fed has struggled to determine just how stimulative the level of rates is. Members had said last year that 2.5% rates were close to neutral. It seems like they think the current level is neutral, but since they’ve cut, they have to say it’s a little accommodative. As far as the outlook, they still have a soft bias towards easing should conditions deteriorate. They can’t be totally confident that the U.S. doesn’t face any further risks or that there is no chance of a recession. On the other side, the level of inflation makes hikes very unlikely in the near term. Powell said as much in his press conference. 10 10 Close During the press conference, Chair Powell stated: “I think we would need to see a really significant move up in inflation that's persistent before we even consider raising rates to address inflation concerns.” Source: Federal Reserve, Chair Jerome Powell: “Chair Powell’s Press Conference Transcript,” 10/30/19.

The market reaction was telling. Because some folks had expected the Fed might signal more easing in the future, the meeting was generally viewed as a “hawkish cut.” When the market sold off initially, some traders may have been viewing the hawkishness as bad for equities, but that quickly reversed, and the S&P 500 made all-time highs. Investors may remember that after the last “midcycle adjustment” in 1998, stocks rallied aggressively as the tech bubble inflated. Perhaps more interesting was the reaction in fixed income over the following week.

Short-term bonds yields, which are most directly affected by Fed expectations, rose as a cut at the next meeting became less likely. However, the yields on longer-term bonds rose more – the yield curve steepened. 11 11 Close From the open on October 30, 2019 to the close on November 5, 2019, the 2yr vs. 10yr Treasury yield curve steepened from 17bps to 23bps, with 2yr yields moving from 1.60% to 1.63% and 10yr yields moving from 1.77% to 1.86%. Source: Bloomberg. This may indicate that the fixed income market is sharing some of the Fed’s optimism. The higher longer-term yields signal a lower chance of recession and confidence that monetary policy may in fact be appropriate. Some Fed members are reading it this way. Dallas Fed President Robert Kaplan said, “I feel better with a more normally shaped yield curve.” 12 12 Close And we feel better when you feel better, Dr. Kaplan. , 13 13 Close Bloomberg: “Robert Kaplan Says Steeper Yield Curve a Sign Fed Rates Now Appropriate,” 11/5/19.

The yield curve is not particularly steep compared to levels in the past, but the days of the inverted yield curve are over. 14 14 Close For now. As long as conditions don’t suddenly take a turn for the worse, the Fed should be on hold. It would take some weak data to get them to cut. The Fed meeting was important, but what made it so important was that it made clear that in the coming months investors can pay less attention to the Fed. This may be exactly what the Fed wants: to lower its profile. The Fed may be subtly conveying the message that while they will help if it’s needed, the economy is not only about monetary policy. Essentially the Fed is saying, “stop looking at us.” Until something happens to move the Fed out of its happy place, trade and politics will be much bigger drivers of macro markets. Fed watchers can take a pause. Let’s hope it’s not brief.


What We Are Watching

Fed Chair Powell Testimony (Wednesday), Vice-Chair Clarida and New York Fed President Williams Speeches (Thursday)
At its October meeting, the FOMC announced its third consecutive 0.25% rate cut, bringing the target range for Fed Funds to 1.50 - 1.75%. This week will feature congressional testimony from Chair Powell on Wednesday, followed by speeches from Vice-Chair Clarida and New York Fed President Williams on Thursday. These events will provide an opportunity for policymakers to adjust the Fed’s messaging if they are unhappy with investors’ interpretation or if events in the last week have impacted their views.

U.S. CPI (Wednesday)
U.S. inflation decelerated unexpectedly earlier this year, facilitating the Fed’s shift from tightening to easing. However, measures of core inflation have picked up again over the last few months as transitory factors weighing on the data have reversed and as tariff increases may have started to impact prices for certain goods. If October data points to a continued pickup in price pressure, it could mean that inflation will return to the Fed’s target sooner than currently expected. Such a development would likely reduce policymakers’ concerns about persistently low inflation, perhaps leading to a more neutral policy bias moving forward.

China Industrial Production, Retail Sales, Fixed Asset Investment (Thursday)
Chinese growth has slowed over the past year. The three important data series released this week, industrial production, retail sales, and fixed asset investment, have been growing near their slowest pace of the past two decades. 15 15 Close National Bureau of Statistics. While increased tariffs and trade conflict between the U.S. and China has received much of the blame, domestic concerns around financial stability, notably in small- and medium-sized financial institutions have also likely had some impact. Given the importance of manufacturing in China’s economy and China’s growing role in the global economy, signs of weakness in industrial production or fixed asset investment could weigh on risky assets. China’s continued push to transition away from investment and towards consumption has also increased the importance of spending-related data such as retail sales. If retail sales show signs of weakness, it could lead to weakness in domestic equities.


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