Trade Wars, Rate Hikes, and a Whole Lot of Maybes

Last week, Federal Reserve Chair Jerome Powell dropped a couple of surprises on Fed watchers.

What didn’t come as a shock was the quarter-point hike to the overnight federal funds rate. Markets were fully prepared for that move.

But they were caught unawares when the Fed highlighted the potential for an additional hike this year. That would bring the total number of hikes in 2018 to four.

Since the March meeting, the Fed revised its median projection for full-year economic growth to 2.7% from 2.6%.

The central bank’s updated outlook also calls for the unemployment rate to dip to 3.6%, an improvement from the previous forecast of 3.8%. A 3.5% jobless rate is the target for 2019 and 2020. Not bad.

Inflation is also expected to tick up. The Fed bumped up its projection for the core personal consumption expenditure (PCE) index – one of the central bank’s favorite inflation signposts – to 2% from 1.9%.

Starting in January 2019, Chairman Powell will conduct a press conference after every meeting. That means traders will have to stay on their toes, as market-moving decisions will be on the table each time. 

Up until now, the Fed chair held a press conference after every other meeting; the market had assumed that, in the absence of a presser, no policy changes would be announced.

More Fed press conferences could create more trading opportunities in the Treasury market. No matter how we feel about the Fed, we’re always in favor of that!

Overall, Powell thinks the U.S economy is in “great shape,” which is reflected in the strong job market. Though he warned that rising oil prices could push inflation beyond the Fed’s 2% target, he doesn’t believe it’ll last long enough to be an issue.

Powell also conceded that the lack of wage inflation was still a mystery, despite labor shortages and low unemployment.

He also mentioned that we’re about four rate hikes away from “neutral.” What does that mean? Our Fed-speak translator tells us that’s Powell’s way of saying that monetary policy isn’t helping or holding back our economy.

There were no questions about the Fed’s balance sheet, but Powell did note that the effort to run off the central bank’s portfolio is proceeding as planned.

Powell didn’t seem too concerned about the yield curve, asserting that a flattening of the curve after a hike in short-term rates was natural.

After the March policy meeting, some participants expressed concern with the yield curve’s slope. Others shrugged it off.

Here’s what I think.

Take a look at the Treasury yield curve since the last Fed meeting in March.

Notice how long-term rates fell while shorter-term rates climbed over the last three months.

Like I’ve said before, a flattening yield curve is a “DANGER!” sign. When the yield curve inverts, the economy will likely fall into a recession.

So, if the Fed hikes twice more this year and a couple more times next year, the overnight rate will sit at about 3%. If long-term rates don’t move much, it’s a near certainty that the economy will contract.

I doubt the Fed will consider that a “neutral” situation…

Of course, the projected policy path doesn’t account for changes in economic growth, inflation, or even the jobs market. If the economy deteriorates, don’t expect those rate hikes to happen.

Cold, Hard Facts and A Lot of Maybes

The Fed meeting wasn’t the only news of significance last week.

Consumer spending has been mixed this year, but low unemployment and slowly rising wages helped drive retail sales sharply higher in May.

Consumer spending accounts for about two-thirds of our economy, while retail sales make up about half of total consumer spending. So, it’s an important metric.

Retail sales were up 0.8% on the month, doubling the market’s expectations. Excluding auto and gasoline sales doesn’t change the magnitude of the surprise.

Normally, Treasury bond yields would spike higher after such a strong report. In this case, long-term yields fell.

Why?

Maybe it’s because the Fed hiked rates last week. Maybe it’s because investors saw that hike as a sign of an economic slowdown ahead.

Or maybe it’s the escalating trade tensions between the U.S. and China. It seems increasingly likely that tariffs are coming down the pike for trading partners that engage in unfair practices… just as President Trump promised.

That’s a lot of maybes. Uncertainty is king for the time being.

The threat of tariffs has already pressured Chinese stocks, which are down sharply over the past few trading days. We’ll see if those concerns spread to other markets.

Will the Fed stay the course and hike rates two more times this year?

I wouldn’t bet on it if the economy weakens, inflationary pressure abates, and wage growth remains contained.

Good trading