FOMC Minutes Reveal Hawkish Sentiment

During the Summer Olympics, no one looks at a 100 meter sprinter and thinks, “I could do that.”  Or watching a guy launch his entire body over a bar nearly 8 feet in the air.  Even the ping pong players look variations of The Flash.

Some of the Winter Olympic events trick you into believing you could do it.  “I can jump into a box and slide down an ice tube to the finish line.”  Or “I could learn to skate around in a circle quickly.”  Heck, even one of the half-pipe competitors qualified by simply traveling around the world and simply riding down without falling.

But the winter events are so misleadingly cruel.  Did you see the Diggins sprint to the finish?  There’s no chance my heart doesn’t explode in that situation.  Even curling requires the ability to bend your knees to a point where you are an inch off the ground.  There is NO WAY I could do that – I basically fall into a chair once my knees hit 45°.  Getting old sucks – thanks for the reminder Winter Olympics.

Last Week This Morning

• The 10 year Treasury ran up to 2.95% on Wednesday on the back of the Fed minutes and their revisions higher to economic forecasts.
• The 2 year Treasury ran up to 2.28% on fears of a fourth hike this year following the Fed minutes. It eventually settled down and closed the week at 2.23%.
• FOMC minutes revealed an increasingly confident Fed about the strength of the economy, the resurgence of inflation, and the need for gradual rate hikes.

Fixed Rates

Heading into last week, 10 year yields had climbed for 7 straight weeks, the longest streak since May 2008.  The last time the 10T had an eight week streak was 1994.  But alas, it was not meant to be. The 10T peaked at 2.95% on Wednesday, but gradually retraced and finished the week at 2.86%, just 1bp below last week’s close.

Much of the retracement came on Thursday after the ECB’s own minutes were released and failed to address potential tapering or eventual rate hikes.  This caused the German bund to drop by 7bps.

If you haven’t caught on by now, the ECB is almost as important to US yields as the Fed.   It’s a complicated diagram, but let’s see if you can follow along:

ECB decisions —-à German Bund yields –à  10 Year Treasury

FOMC Minutes

Ahead of the minutes release, three Fed members hit the wires to massage the message:

• Uber-dove Kashkari reiterated that one strong month of inflation a trend does not make. He is on record as saying the Fed should not hike until inflation actually hits 2.0% and dissented at last year’s rate hike meetings.
• Moderate Harker said two hikes this year is still appropriate.
• Slightly hawkish Kaplan has concerns about waiting too long but believes the pace of hikes should be gradual.

Well that cleared everything up…

Hawk-Speak (meaning the Fed may hike faster than expected)

• “A majority of participants noted that a stronger outlook for economic growth raised the likelihood that further gradual policy firming would be appropriate.”

• “Almost all participants continued to anticipate that inflation would move up to the Committee’s 2% objective over the medium term as economic growth remained above trend and the labor market stayed strong; several commented that recent developments had increased their confidence in the outlook for further progress toward the Committee’s 2% inflation objective.”

• While risks to the forecasts are “roughly balanced” according to the Committee, “several” participants have suggested that upside risks to the near-term outlook may have increased.

• “a number” of participants indicated that they had revised their forecasts for economic growth in the near term in light of the strength of recent data and expected growth from the tax cuts.

Not Quite Hawk Speak (not strong enough to refer to these as “dovish”)

• Some participants see “an appreciable risk that inflation would continue to fall short of the Committee’s objective”.

• “Several” participants noted that “imbalances in financial markets may begin to emerge as the economy continued to operate above potential.”

• Concern over the lack of wage growth remains, as “participants generally noted few signs of a broad-based pickup in wage growth in available data.”

Bottom Line – these minutes were largely hawkish and confirm the Fed intends to hike three times this year.  This would push LIBOR to 2.25% – ish by year end.

There is more and more talk from market commentators of a fourth hike, which would put LIBOR at 2.50%-ish by year end.  Absent a sharp pick up in inflation, we are skeptical.  Changing the path of rate hikes lower is almost universally welcomed.  The Fed can hold off and the market will be happy with the change.

But changing the path higher could spook markets and cause a sharp correction in equities.  Furthermore, the Fed has openly discussed allowing inflation to run hot in order to compensate for a decade of below-growth inflation.  The Fed would absolutely need permission from the market to pull off a fourth hike, so if that is even a remote possibility they will start with trial balloons to gauge the market reaction.

In the last five years, there has been exactly one surprise inflation report to the upside – last month.  If that trend continues through April or May, we could see the Fed start to wonder about a fourth hike.  But let’s see whether January’s inflation data was an outlier or the start of a trend before jumping in with a fourth hike.

In order for Fed’s projections to change to four hikes this year, four out of the six members projecting three hikes would need to revise their forecasts higher.  That’s a big movement with just one strong inflation print under our belt.

But…if data continues to come out strong and inflation continues to surprise to the upside, we could see signals from the Fed testing the market sentiment on a fourth hike.  If the market takes it in stride, a fourth hike could be on the table.  Heck, Goldman is already suggesting a fifth hike is possible…

ECB Meeting

The ECB meeting was largely uneventful, but the market interpreted the lack of tapering discussion as dovish.  Draghi reiterated that the growth outlook in the eurozone had improved and confidence about inflation was picking up.  But the minutes also revealed these beliefs are based on continued and ample accommodation.

The first step for the ECB, like it was here, will be the tapering of its monthly bond purchases, eventually winding down to the point where the ECB is no longer buying bonds each month.  We expect that to come sometime around Q4 of this year, but the market will respond well before that based on comments by the ECB.

The next step, as it was here, will be to hike short term rates.  Remember Yellen’s Q&A when a reporter asked her how long between the end of bond purchases and the first rate hike?  She botched the answer and suggested it was two or three meetings and the market revolted.  She never answered a question directly again and Draghi will have learned from that.

Once Draghi provides a timeline for the end of QE in the eurozone, questions will turn to the first rate hike.  Whether the ECB squeezes a hike in late 2019 or not is probably not newsworthy, the market will be more focused on the path of rate hikes over say a three year time horizon.

Why does this matter?  Because the eurozone is awash in negative yields, which serve as a drag on US yields.  If the German bund is yielding 0.70% and the UST moves from 2.90% to 3.25%, the US yield looks that much better than it did before the move.  Money starts flowing into the UST, bringing the yield back down.

The opposite is true as well.  If the German bund jumps from 0.70% to 1.50%, it gives the UST that much more room to move higher.

Think about how much higher the 10T has climbed since the end of QE and the start of the tightening cycle – about 1.50%.  A similar response by the Bund as a result of the ECB’s own removal of accommodation could apply substantial upward pressure on yields here.

This Week

Busy week ahead, with Jay Powell making his first appearance before Congress on Tuesday.  Powell, while viewed as the continuity candidate, is still an unknown quantity.  His testimony, therefore, represents risk.

Just as Yellen learned in her first Q&A, it can be challenging to stick to the boring, monotone, scripted Fed-speak.  Markets promptly punished Yellen and she didn’t make the same mistake again.  Powell’s every word will be analyzed.  A verbal misstep could roil markets.

Lots of economic data and Fed speeches as well.

Monday – dove Bullard speech
Tuesday – preliminary Q4 GDP and durable goods
Wednesday – Core PCE (Fed’s preferred measure of inflation)
Thursday – Manufacturing and Dudley speech