If You Don’t Have Time This Morning
The Fed’s near-term path is clear, with a series of likely three and maybe more 50bp hikes beginning at the May FOMC meeting. Although it seems like there should be a point we should stop pricing in additional rate hikes, it is difficult to shift gears until the data shows signs of moderating inflationary pressures. Otherwise, the Fed has been remarkably complacent in validating seemingly any market pricing. Higher interest rates should start showing some results.
Recent Data and Events
We are at the stage of the cycle where the game becomes watching the data for signs that spending is beginning to crack under the weight of higher interest rates. Housing becomes the central focus given the short channel between policy signals and mortgage rates, the latter rising sharply in recent weeks. Now we need to sort through the consequences. At a basic level, the rise in rates will shake out the weaker players and stem the pace of home price appreciation, but as I have written in the past factors such as income growth, demographics, and inflation expectations lean the other direction. About inflation expectations, for example, though the increase in long rates has been rapid in both nominal and real terms, 30-year real mortgage rates remain in their recent range while 5-year ARMS are still a relative bargain:
New buyers could reasonably take on ARM financing on the expectation that over the next five years the Fed induces a recession and presents buyers an opportunity to refinance into a 30-year rate at that point. This would help mitigate the immediate impact of higher rates – at least until ARM rates rise further.
...Fed Speak and Discussion
Federal Reserve Chair Jerome Powell wiped away any residual doubt about the near-term policy path. Last Thursday, Powell said that a 50bp hike was on the table for the May meeting. While he wouldn’t say if 50bp was already a done deal, he effectively took the guidance one step further, saying “[t]here’s something in the idea of front-loading” rate hikes, which speaks to the expectation for a string of 50bp rate hikes. There really is no question about what is happening here – moving “expeditiously” to a more neutral policy setting by the end of the year requires stepping up the pace of rate hikes to 50bp increments. As of now, 50bp rate hikes in May and June are all-but-certain, July very likely, and August, assuming the inflation or employment data continue to dispel hope that price pressures will endogenously moderate enough to put the Fed’s inflation target in sight...
...An even bigger hike of 75bp is not happening. St. Louis Federal Reserve President James Bullard has discussed the possibility of the larger hike, something former Federal Reserve Chair Alan Greenspan pushed through in 1994, and an option we questioned Bullard on at an SGH/Columbia event on February 17th. Bullard looks favorably on the 1994-95 cycle as an example of where the Fed managed a soft-landing in the context of aggressive policy action on both sides of peak rates for a cycle. That said, the consensus at the Fed is not eager to surprise markets with a bigger move at the next meeting. That includes the generally hawkish Cleveland Federal Reserve President Loretta Mester who made clear last Friday that in her view 75bp was not needed. Remember, the Fed wants to move expeditiously but doesn’t want to break the economy or markets in the process. Still, arguably Bullard has planted the seeds for the bigger move at the June meeting, and it may be a more attractive option at that point, just as the possibility of 50bp moves was scoffed at back in January, although I find it unlikely...
...While the idea of “neutral” sounds like a promising pausing point, the Fed lacks confidence that it can pause at neutral. Fed speakers repeatedly discuss the possibility of moving past neutral, something already evident in the March Summary of Economic Projections but even those forecasts are all-but-certainly too optimistic if unemployment keeps falling while inflation remains stubbornly high. I think the Fed knows this but remains wary to push this story too far because it is obviously in tension with the soft-landing story it is trying to sell.
Moreover, neutral is a moving target. Clients frequently ask if the Fed’s view of neutral is moving, and the answer is that we don’t see any indication that is happening yet. Fed speakers have largely centered that on a 2.25-2.5% range for some time now. Thinking on it, I don’t think the Fed can easily change this estimate. Consider that it follows from a forecast of the real neutral rate plus the Fed’s inflation target. The former is difficult to observe in real time and the latter is fixed. A more appropriate estimate of the inflation component is arguably derived from 10-year TIPS break-evens, currently 3%. Subtracting 30bp as a rough conversion from CPI to PCE inflation makes that 2.7%, which combined with a 0.5% real rate suggests the true neutral rate is currently around 3.2%. The same exercise using the 5-year breakeven suggests a neutral rate of 3.6%. Arguably, these are estimates of the near- or medium-term neutral rate, while the Fed’s reported number is a long-term estimate. Still, this exercise suggests to me that monetary policy will remain stimulative until policy rates climb above 3%...
Policy Validation @LenKiefer 5/11/22
reARMing the U.S. mortgage market share of mortgage applications with adjustable rate increases to over 10%, highest share since 2008
The Federal Reserve raised interest rates by the steepest increment since 2000 and decided to start shrinking its massive balance sheet, deploying the most aggressive tightening of monetary policy in decades to control soaring inflation.
The U.S. central bank’s policy-making Federal Open Market Committee on Wednesday voted unanimously to increase the benchmark rate by a half percentage point. The Fed will begin allowing its holdings of Treasuries and mortgage-backed securities to roll off in June at an initial combined monthly pace of $47.5 billion, stepping up over three months to $95 billion.
“The committee is highly attentive to inflation risks,” the Fed said in the statement, adding a reference to Covid-related lockdowns in China that “are likely to exacerbate supply chain disruptions.” That comes on top of Russia’s invasion of Ukraine and related events, which are “creating additional upward pressure on inflation and are likely to weigh on economic activity.”
FOMC Press Conference
>> CHAIRMAN JEROME POWELL: I don't think one month, one month is not, no, one month's reading would not, doesn't tell us much. We want to see evidence that inflation is moving in a direction that gives us more comfort. We have got two months now, where core inflation is a little lower but we are not looking at that as a reason to take some comfort. We need to really see that our expectation is being fulfilled, that inflation in fact is under control, and starting to come down. But again, it is not like we would stop. We would just go back to 25 basis point increases. It will be a judgment call when these meetings arrive. But our expectation is if we see what we expect to see, we would have 50 basis point increases on the table at the next two meetings.
White-pack (Jun22-Mar23) eurodollar futures outperform across the strip after Fed’s Powell says 75-basis-point rate hike moves are something the FOMC is not actively considering.
Jun22 eurodollar futures flip to higher by 11bp on the day and outperform across white-pack futures as rate-hike premium continues to ease out of the front-end of the curve
Further out 2-year yields richened by up to 12bp on the day at around 2.66%, steepening 2s10s curve sharply wider -- to steeper by 7bp on the day; further out, the 5s30s curve widens 9bp on the day amid front- and belly led gains
FOMC Press Conference
>> CHAIRMAN JEROME POWELL: So, neutral, when we talk about the neutral rate, we are talking about the rate that neither pushes economic activity higher nor slows it down. It is a concept. It is not something we can identify with precision. We estimate it within broadbands of uncertainty. The current estimates on the committee are two to three percent. That is a longer run estimate. That is a estimate for a economy that is at full employment and 2 percent inflation. The way, what we are doing really is we are raising rates expeditiously to what we see as the broad range of plausible levels of neutral. But we know that there is not a bright line drawn on the road that tells us when we get there. We are going to be looking at financial conditions. Our policy affects financial conditions and financial conditions affect the economy. We are going to look at the effect of our policy moves on financial conditions, are they tightening appropriately. We are going to be looking at the effects on the economy. We are going to be making a judgment about whether we have done enough to get us on a path to restore price stability. It's that. So if that path happens to evolve levels that are higher than estimates of neutral, we will not hesitate to go to those levels. We won't. But again, there is a false precision in the discussion that we as policymakers don't really feel, it's you are going to raise rates and going to be inquiring how that is affecting the economy through financial conditions, and of course if higher rates are required, then we won't hesitate to deliver them.