Powell's First Dance with Congress: Hawkish.

I guess I’m not much of a Fed watcher. There’s something I don’t like about the Kremlinology aspect of parsing a Fed governors words. Sell side economists, financial media, and no small amount of fin-twitter opine on every speech as if it is potentially a game changer for monetary policy, rates, and the value of the dollar. However, when you have a new chairman of the Fed, it pays to sit down and listen to the guy for his first speech in front of congress, because he is going to bring his own style to the proceedings--and ya never know….maybe some new substance.

So this passage stood out:

“In gauging the appropriate path for monetary policy over the next few years, the FOMC will continue to strike a balance between avoiding an overheated economy and bringing PCE price inflation to 2 percent on a sustained basis.”

I can’t remember the last time a Fed chairman used the words “overheated economy”, and the unequivocal statement that they will manage monetary policy is such a way to avoid it.

What is more peculiar about this statement is not just the hawkish implications--but the clear implication that the level of PCE price inflation is potentially mutually exclusive from an overheated economy. When you consider that in the context of a dual mandate--it illustrates what I think is a big trend in central banks around the world since the financial crisis: There is a stealth mandate to maintain financial stability, or at the very least an implicit one embedded in the stated mandate of all central banks.

What does that mean for the hiking cycle, and for rates at large? Clearly it is hawkish. It is also argues that Powell is looking at:

1) an economy at full employment,

2) inflation somewhat convincingly, but not conclusively, ticking higher,

3) higher commodity prices ( mandate is HEADLINE inflation, not core...so this matters, even if they don’t say so), but also importantly

4) a government that is bound and determined to borrow and spend money like a drunken sailor on leave,

5a) financial conditions at increasingly easy levels,  5b) credit growth starting to tick up, and 5c) financial markets showing some signs of froth, reaching for risk, etc.

Add those factors to a Federal Reserve that has the institutional memory of a financial system that exploded at the end of a three year hiking cycle, despite modest upticks in inflation, and you can paint a picture of a chairman that might look to be more aggressive in reigning in excess than his predecessors--even if the past several years of central bank policy history seem to imply that monetary authorities shouldn’t pump the brakes too fast as economies recover and financial markets recapitalize.

Which leads us back to what we all really care about, WIPI. What Is Priced In?

The Powell testimony put paid to the front end again….but took levels pretty much in line with “the dots”:

75bps this year….yes three hikes, on the screws with what was in the December SEP. But the cycle peters out after that, with roughly 30bps priced in for 2019.

Here is a mockup of the impact from Powell’s speech, using 3m OIS rates at various forward tenors.   

More simply, the front end 3m rates were far more stable than the 3m rates one year, two years and five years in the future.

It’s a bear steepener in the front end--but consistent with the type of policy shifts that can put a bid into the long bond--higher front rates amid stable long-term flows. And looking at the outright levels of those 3m forward rates, the levels five years out-somewhat consistent with where the market’s estimation of a “neutral rate” might be-- are only just now reaching that seemed sorta normal-ish between 2011 and 2014.

Bottom line, the market isn’t counting on a bear steepening in the front end relative to the belly of the curve, but the combination of fiscal stimulus, high commodity prices and a hawkish FOMC chairman might just do it---and shepherding the curve slowly but surely in that in that direction might be the best way for Powell to let some air out of this balloon global central banks inflated over the past decade.

2y/5y OIS is sitting at 25bps--unless Powell moves decisively towards four hikes this year, the market might shift towards higher rates later rather than sooner...especially if it is appearing that wages are taking more time to accelerate than many seem to expect.  

Yeah, I know….US economic data is already starting to tail off...commodities have seemed to find a level here...and yes, maybe there is something to the impact of higher rates on the housing market. And I believe the most convincing argument in favor of lower rates from these levels is the unwavering commitment of the ECB and BoJ to keep rates right where they are. Suddenly nearly 3% in dollars doesn’t sound so bad. As such I don’t think the long bond is going to far.  But when the long-term neutral ex-ante real rate is at 50bps, there is still room for that to move higher.  

Why did I use OIS rates here? I wanted a clean picture of Fed-implied policy rates since LIBOR and swap spreads have undergone some big policy-driven changes over the past couple of months...who said US rates are boring!! Stay tuned for more on that subject on Friday.

Shawn
TeamMacroMan2@gmail.com
@EMInflationista