Tim Duy’s Fed Watch, 4/25/22

Published on April 25, 2022
SGH Insight
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%...
Market Validation
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

Bloomberg 5/4/22

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.

Bloomberg 5/4/22

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.

Monday Morning Notes, 4/25/22

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.

A combination of low inventory, high prices, and higher interest rates appear to be taking the steam out of the existing home market as expected. Existing home sales fell 2.7% in March and stand 4.5% lower than a year ago. Still, the median price climbed 15% over the past year and not all analysts believe rates are biting significantly just yet. Via the Wall Street Journal:

“The number of people who are in the market has been reduced, but so has the number of homes on the market,” said Robert Frick, corporate economist at Navy Federal Credit Union. “If mortgage rates rise much further, I think they will start becoming a factor, but I don’t think they’re a factor yet.”

In contrast, housing starts remained solid in March:

While the gap between start and completions widened further:

Buyers that purchased a new home but have yet to take delivery due to construction delays and now face higher mortgage costs may be a good target group to take advantage of the lower ARM rates.

As of April, builder confidence remains strong despite sharply higher mortgage rates:

Interestingly, buyer traffic remains above pre-pandemic levels:

This signals that although the weaker hands have fallen out of the market, there are still plenty of strong hands to sustain overall demand which, if true, implies that rates need to rise considerably further to induce the changes in demand the Fed seeks. An interesting possibility is that if the Fed has set in motion a 1970s-style economy, it will need to hike rates until it forces a hard rollover in housing activity, which in turn would force the Fed to reverse course and cut rates, thereby forcing buyers back into the housing market. I don’t think we see forced selling like in the GFC period, so the best strategy of both buyers and sellers is to manage behavior in the context of the expected rate cycle. Potential sellers could rush to put homes on the market now to top-tick prices but would be better off just waiting for rates to fall. Buyers have a similar incentive. The housing market then becomes characterized by a start/stop dynamic. I don’t feel like we put enough weight on a return to short but sharp cycles, just as we didn’t put enough weight on inflationary scenarios.

The S&P US Composite PMI flash number for April was mixed with stronger manufacturing but softer services. Still strong demand on the services side:

Demand conditions remained buoyant, however, as new orders rose sharply. The uptick in new sales was linked to the loosening of COVID-19 restrictions, especially for client-facing businesses. That said, the pace of expansion in new business also eased to a three-month low amid reports of labor and supply shortages and inflation dampening customer willingness to spend.

But firms continue to push through price hikes:

Meanwhile, cost burdens continued to soar, as the rate of input price inflation accelerated in the service sector to a series-record pace. Higher wage and input bills stoked the increase in costs. In response, service providers hiked their selling prices at the steepest rate on record in an effort to pass-through greater cost burdens.

The Fed bet the farm on the hypothesis that inflation would be “solved” by a transition to service sector spending, and an assumption that transition would happen without higher prices in that sector. Feels like the Fed continues to be on the wrong side of that trade. Sadly, it is not evident that the Fed will get much of the expected relief from the goods side of the equation:

Inflationary pressures remained marked across the goods- producing sector in April. The rate of increase in costs quickened again to the sharpest since last November’s series record amid reports of hikes in fuel, material and transportation prices. Frequent increases in costs resulted in the sharpest rise in output charges on record as firms sought to pass-through greater input prices to clients.

At its core, inflation is a macroeconomic phenomenon, but the Fed lost that focus after a long period of stable inflation shifted inflation forecasting to a bottom-up approach that convinced the Fed inflation is a microeconomic phenomenon. I believe the Fed is now paying for that loss of focus. On the bright side, a little inflation helps “make macro great again.”

Upcoming Data and Events

A good, busy data week to give us something to chew on while waiting for next week’s FOMC meeting. March durable goods orders are released Tuesday, with core orders expected to be 0.5%. Wall Street expects new home sales for March (also Tuesday) were effectively flat, which would be good news given rising mortgage rates. Mortgage applications data comes on Wednesday; soft numbers would not be a surprise, but as noted above there are lots of factors besides rates at play. Also, on Wednesday is pending home sales. On Thursday we get first quarter GDP numbers. Wall Street expects a meager 1% and there is a real possibility of a negative print. Don’t worry about that either as the details will be stronger than the headline. While economic activity is decelerating, the pace of underlying activity remains close to 5% year-over-year:

Personal income and outlays data for March arrives on Friday. The key number to watch is core-inflation, expected to be up 0.3%. Like with the March CPI numbers, this will give some hope to Fed doves that the worst has passed, but the consensus will need more evidence of sustained disinflationary pressure to ratchet back the hawkishness. Also, this week will be consumer sentiment data for April from the Conference Board (Tuesday) and the University of Michigan (Friday).

Blackout period for the Fed.

DayReleaseWall StreetPrevious
TuesdayCapital Goods Nondefex Air, Nov. P, MoM0.5%0.7%
TuesdayConference Board Confidence, Apr.107.5107.2
TuesdayNew Home Sales, Mar.774k772k
WednesdayMBA Mortgage Applications, Apr. 22-0.5%
WednesdayPending Home Sales, Mar.-0.5%-4.1%
ThursdayInitial Jobless Claims180k184k
ThursdayPersonal Income, Nov., MoM0.5%0.5%
ThursdayGDP Annualized, 1Q, QoQ1.0%6.9%
FridayPersonal Spending, Mar., MoM0.6%0.2%
FridayPCE Prices, Mar., MoM0.9%0.6%
FridayCore PCE Prices, Mar., MoM0.3%0.4%
FridayUniv. Of Mich. Sentiment, Apr. P65.765.7
FridayUniv. Of Mich. 5-10Y Inflation Exp., Apr. P 3.0%

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.

A somewhat frustrating aspect of policy at this juncture is that all we can do is to continue to price in additional rate hikes. Maybe not 75bp hikes, but we can price in a fifth 50bp hike. While there must be a limit to how much the Fed wants us to price in today, other from some pushback from soon-to-be Federal Reserve Vice Chair Lael Brainard, Fed speakers are largely validating whatever pricing the market delivers. The Fed has eschewed forecast-based policy in favor of a stricter focus on incoming data, and Wall Street expects that data to largely favor the Fed’s ever-more-hawkish policy path. It seems that we need the Fed to shift back to forecast-based policy or the data to shift markedly before we can talk more earnestly about a potential policy plateau. Lost in the discussion is the potential impact of quantitative tightening. If quantitative tightening has a bigger than expected cumulative impact, then the Fed risks letting rate pricing get too far ahead of itself.

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%.

The Fed will likely more frequently distinguish between short- and long-run neutral rates. Chicago Federal Reserve President Charles Evans did so last week:

“On the way to December you’d be looking for any confirmation of the storyline,” Evans said. “It could be that short-term neutral is actually lower, and that by the time we get to 2.5, it’s actually contractionary for a variety of reasons. It could go the other way too,” he said.

The Fed has made this distinction in the past. Brainard in 2018:

Focusing first on the “shorter-run” neutral rate, this does not stay fixed, but rather fluctuates along with important changes in economic conditions. For instance, legislation that increases the budget deficit through tax cuts and spending increases can be expected to generate tailwinds to domestic demand and thus to push up the shorter-run neutral interest rate. Heightened risk appetite among investors similarly can be expected to push up the shorter-run neutral rate. Conversely, many of the forces that contributed to the financial crisis–such as fear and uncertainty on the part of businesses and households–can be expected to lower the neutral rate of interest, as can declines in foreign demand for U.S. exports.

In many circumstances, monetary policy can help keep the economy on its sustainable path at full employment by adjusting the policy rate to reflect movements in the shorter-run neutral rate. In this context, the appropriate reference for assessing the stance of monetary policy is the gap between the policy rate and the nominal shorter-run neutral rate.

Leaning on the idea of a short-run neutral rate could potentially help the Fed lift estimates of the terminal rate while at the same time retaining the soft-landing story. Essentially, the Fed will be able to say it won’t be raising policy rates as far beyond neutral as it might look, thus the risk of recession is less than it appears.

Watch for increased signaling about the expected level of terminal rates in the wake of the May FOMC meeting. As I wrote last week, the Fed is doing a better job of signaling the likely direction of the next SEP, and I think this will continue. I suspect next week the Fed will advance the discussion of how participants view the terminal rate and how they want to communicate this information ahead of the June meeting. If recent history is a guide, Powell will give us a hint of the content of the minutes during the press conference, and this will serve as our forward guidance for roughly the next two meetings.

Bottom Line

Full steam ahead for the Federal Reserve. The train is on the straightaway, leaving us peering into the future looking for that next curve that forces the Fed to ease back on the throttle. Not seeing it yet.

Good luck and stay safe this week!

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