A couple tour guides
Now, the question is, “Where are we headed?” Fortunately, we still have some respectable guides to give us some insight. Let’s take a current look at a couple of key economic indicators we will be watching closely. But first, let’s see what the market thinks about the potential for a Fed cut later this year. As you might expect from recent news, the probability of a Fed easing has climbed steeply over the past few months — from less than 20% chance in the first quarter to almost 100% currently. So, the market is showing good odds of a Fed cut on or before the December 2019 Fed meeting. Let’s see what is driving that thought.
Inflation is always a good guide for market prognosticators. In the second quarter of 2018, it appeared as if the Fed was making progress in attaining their 2% target for inflation as measured by their preferred core price gauge, the Personal Consumption Expenditure Index (PCE). Unlike the better known Consumer Price Index (CPI), the PCE is not the price change of a fixed basket of goods. It is a broader and more nuanced guide of price changes as well as changes in consumers’ shopping habits. Hitting the 2% level last March gave the Fed confidence to hike interest rates four times through 2018 — from 1.5% to 2.5% (upper bound). However, inflation has fallen quickly from this level over the first half of 2019. The Fed is attributing this decline to transitory factors. Unfortunately, it’s not clear what they meant by transitory and how long this transition is expected to last. Why do they say it’s transitory? They are looking at a “trimmed” PCE calculated by the Dallas Fed. This trimmed inflation measure throws out certain outliers. It is currently at 2.0% for the 12-month period and has not declined like the un-trimmed PCE.1
Perhaps a more important measure of inflation for investors to watch is wage inflation. The tight labor market is starting to push up wage inflation as measured by changes in average hourly earnings. Annual wage inflation has increased strongly, from 2.6% to 3.4% over the past year. This could feed into consumer prices directly from increased production costs or from stronger consumer buying power, i.e., increased demand. This has yet to occur, but the Fed continues to look for signs of wage-driven inflation.
The bond market’s historic recession indicator is an inverted curve where short-maturity bonds yield more than longer maturities. Many articles have highlighted this relationship after the first inversions earlier this year. Some have argued that a curve inversion, in this new world of global quantitative easing and extremely low and negative interest rates, is not a reliable predictor of a recession. That remains to be seen, but it does highlight investor angst over future economic growth. Last year, the 10-year yield was about 100 basis points (one percentage point) higher than the yield of a three-month bill. Now, it’s about 22 basis points lower in yield, the first time since 2007. The longer the curve remains inverted, the more concerned we will be about a potential recession.
One thing an inverted yield curve may help spur is a preemptive cut by the Fed, or what the media has been calling an insurance cut. Market expectations for a rate cut shot up in early June after Fed Chairman Powell stated the Fed is standing ready to cut rates if the economic outlook deteriorates on trade concerns. With low global rates and the expectation of a rate cut, it’s hard to see a major correction higher in bond yields. We would need a number of economic surprises to the upside.
What we expect
There are many other indicators we could discuss to help guide us on the strength of the economy and the Fed’s next move. If inflation continues to decline, we are more likely to see a rate cut in the next couple meetings. If it creeps higher and does prove to be transitory, we will likely see the Fed stop talking up rate cuts. As for the inversion in the Treasury curve, its indicative of the market’s belief that the economy is slowing and that the Fed will have to cut rates. The curve has not been inverted long enough to predict a recession, but the clock is ticking. Other recent insights:
- Second quarter growth will be weak; the Atlanta Fed’s GDPNow 2Q forecast is currently 1.5%.
- Wage inflation will continue to increase with the tight job market. This will feed into core price inflation measures, the question is at what speed this will occur. The counter argument is that globalization and automation are containing prices.
- With inflation consistently below the Fed’s 2% target, they are concerned that consumers and businesses don’t believe the Fed will hit its target, i.e., inflation expectations will fall, which can become a self-fulfilling prophecy. This is also a motivation for the Fed to cut in the near future.
- Talk of further tariffs — like the President threatening Mexico due to immigration — will tend to keep bond yields suppressed. Almost 5 million U.S. jobs are tied to trade with Mexico. Slowing that trade flow will impede growth. And threats of tariffs are now being used for non-economic reasons; who’s next?
- While housing price gains will continue to slow, we should see improvements in housing sales. Mortgage applications are at multi-year highs due to falling rates, which are down almost 1% from last year.
- The U.S. economy added 75,000 jobs in May with the unemployment rate steady at 3.6%. Still growth, but a miss from expectations of adding 175,000 jobs with March and April downward revisions as well. The timing of this expectations miss is pushing bond yields lower and giving the Fed additional impetus to cut rates to help soften the U.S. slowdown.
Ultimately, we have to say that a rate cut over the next two months appears likely. Mostly from an “insurance” standpoint. The Fed wants to increase inflation expectations and is willing to let inflation move above their 2% target. A rate cut at this time would help that and support a nervous equity market. The Fed will have a tricky job messaging their intentions to a jittery stock market in the coming weeks and at their June meeting. We expect bond prices to remain firm and trade sideways as multiple cuts are already priced into the market.