Ease to please! It was a Fed-head fiesta as markets roared upward yesterday in response to the Fed Chairman’s ever-so-slightly dovish speech in the largest positive move since earlier in the year. Markets began yesterday’s session with a positive posture ahead of what might have been a run-of-the-mill Fed speech at New York’s Economic Club. But it wasn’t meant to be… run-of-the-mill that is. The big debate amongst Fed governors, economists, and speculative traders during this Fed tightening cycle has been over the so-called “neutral” rate. That neutral rate, for those that care, is really called R* (R-star), and that is the short term real interest rate at which the economy is neither slowing down or speeding up… neutral. As one might guess the complex and large US economy is not like a sports car in which the driver can downshift, cruise, break, or speed up in a millisecond. It is not even like an 18 wheeler on a rainy day in which the driver has to carefully plan and execute every breaking and turning maneuver. The US economy is more like a perfectly balanced, fully loaded cargo ship in which moves need to be planned miles in advance and less-than-perfect execution can spell disaster. Ok, it doesn’t have to be that dramatic, but you get the picture: the economy is not an easy thing to manipulate and the Fed agrees. Powell in many of his past speeches acknowledged the difficulties in projecting and controlling the economy through interest rate hikes. Markets like certainty, and with the Fed being one of the key risks these days all eyes have been on Powell. In a speech earlier this year the Chairman admitted that we were a long way away from neutral rates to perhaps ease fears that the economy would slow down any time soon. The markets read that statement as: “many more hikes to come” causing markets to sell off and interest rates to go up.
This week was filled with many Fed speeches and as one might expect, R* was the star of every discussion (no pun intended). Powell, who is a matter-of-fact, practical speaker usually sticks to the party line, which was largely expected yesterday. For the most part he did stick to the script except for one line in which he said that we are “…just below the broad range of estimates of the level that would be neutral to the economy…” For a numbers guy like me that means nothing as the “broad range” is between 2.5% to 3.5%. For an optimist that wants to see stocks trade up that means he has turned more dovish since his earlier in the year speech. For the record, we are three hikes away from the middle of that range of 3%, which would mean one more hike this year and 2 next year. Until yesterday, the markets were on the fence on whether there would be 2 or 3 hikes in 2019 and the Chairman’s speech just confirmed, well nothing really, because if you assume that R* is at the top of the range at 3.5% that would mean 3 hikes next year. So nothing really new except for maybe the way in which he carefully delivered the numbers. There is currently an 82.7% chance of a 25 basis point rate hike and the probability of 3 hikes next year has now gone to 2 based on Fed Funds futures. Bear in mind all of that is subject to change because the Fed is “data dependent” and if conditions change so will the Fed. But it is also important to bear in mind that there are no rules that say the Fed has to stop tightening when they reach R*. One thing is certain: the Fed is in a rate hike regime and that is unlikely to change. The biggest unknown is the pace at which they will hike, so from an investment standpoint, industries that are highly dependent on debt, things are only going to get tougher. Just how tough and how fast? That is still up in the air.
This afternoon, we may get some more insight into that big question as the Fed will release the minutes from its last policy meeting. Traders will parse the text carefully to see just how much governors are factoring in recent market volatility, currency strength, and trade-related stress in their policy decisions. In this now-overbought and hair trigger market, slight nuances in the text can have large impacts. This morning, we get some real numbers in the PCE deflator (personal consumption and expenditure), which gauges inflation at the consumer level. The number is expected to come in at +2.1% year over year growth versus last month’s +2.0% growth. The Core PCE deflator, which factors out volatile food and energy (remember Crude Oil) prices, is expected to come in at +1.9% year over year versus last month’s +2.0%. I know that I have used the word “Fed” too many times in this note, but I have to mention that PCE is one of their favorite indicators. That said, any deviations from expectations will also have implications in today’s trade. Expect much more talk about Powell’s semantics today even though the market has already voted. In the midst of yesterday’s passion the weekly EIA report on crude inventory showed a greater than expected supply causing crude to trade down and WTI has since traded below $50, which will certainly affect trading today. Finally, there will be much discussion around a possible deal with China as the President heads to Buenos Aires for the G20 summit. With the Fed out of the way for now (at least in traders’ minds), Chinese trade tension is the last big unknown, so all eyes will be on the Administration. Please call me if you have any questions.