U.S. Bond Market Week In Review: Yes, A Downside Does Exist

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Includes: BIL, DFVL, DFVS, DLBL, DLBS, DTUL, DTUS, DTYL, DTYS, EDV, EGF, FIBR, FTT, GBIL, GOVT, GSY, HYDD, IEF, IEI, ITE, PLW, PST, RINF, RISE, SCHO, SCHR, SHV, SHY, SST, TAPR, TBF, TBT, TBX, TBZ, TLH, TLO, TLT, TMF, TMV, TTT, TUZ, TYBS, TYD, TYNS, TYO, UBT, UDN, USDU, UST, UUP, VGIT, VGLT, VGSH, VUSTX, ZROZ
by: Hale Stewart

Several Fed governors spoke this week. President Harker wouldn't take rate hikes off the table. President Powell agreed. But doves still exist. Fed President Williams, whose comments were based on recent SF Fed research, argued low rates would be with us for some time. Hence, there was little need to raise rates. Fed President Kashkari based his dovishness on a belief that there is still a larger-than-desired amount of slack in the labor market.

Overall, here are the primary differences between the hawks and doves.

  1. The doves focus almost exclusively on broader measures of labor underutilization, such as the U-6 unemployment rate or the increasing number of people re-entering the labor force over the last year as the jobs market has tightened. The slow pace of wage growth bolsters this theory. The Atlanta Fed's labor market spider chart provides the best illustration of this utilization weakness:
  2. The hawks, meanwhile, see the economic risks as evenly balanced. They are also growing concerned about getting behind on interest rate policy; they believe inflation could increase at a faster pace, forcing the Fed to raise rates at a faster-than-desired level, creating an economic drag.

In addition, the minutes contained a very interesting paragraph that explained the Fed's concerns about downside risk. While it may seem far-fetched to make that argument in the current environment, numerous such risks exist.

They also judged that near-term risks to the economic outlook appeared roughly balanced.

On the surface, this statement appears to be at odds with the data. The long leading indicators point to modest growth, as does the combination of leading and coincident numbers. But scratch the surface, and downside risks appear. GDP and productivity growth is weak. Even a modest economic challenge (for example, an oil price spike of $20/bbl or a major economic player like the EU disintegrating) could lower GDP to 0%. The U.S.' interest rate policy compounds this problem. In the event of an adverse event, the Fed's actions would be more symbolic than meaningful. And a Republican-controlled Congress would be far less likely to pass a Keynesian-styled stimulus package.

Participants again emphasized their considerable uncertainty about the prospects for changes in fiscal and other government policies as well as about the timing and magnitude of the net effects of such changes on economic activity. In discussing the risks to the economic outlook, participants continued to view the possibility of more expansionary fiscal policy as having increased the upside risks to their economic forecasts, although some noted that several potential changes in government policies could pose downside risks.

Immediately after the election, Trump's promise to lower corporate taxes and pass a large infrastructure spending bill caused a sharp increase in business sentiment. Both of these policies would increase growth. But a month into the new administration, both campaign promises are in danger. The Democrats have slowed the approval of cabinet nominations, consuming precious oxygen on the Congressional calendar. And infighting between the more conservative and moderate elements of the Republican Party are adding to the policy morass. This greatly affects the timing and magnitude of Trump's agenda.

And this doesn't include an analysis of Trump's repeated assertion that he'll raise border tariffs. This would have a profoundly negative impact on trade, which not only supplies final goods and services to U.S. consumers, but is also an integral component of the modern corporate value chain. For example, the U.S. auto industry is now built on a cross-border assembly process involving Canada and Mexico. Not only would an increase in border taxes slow international trade and potentially U.S. corporate growth, it could also lead to a trade war - a potentially destabilizing macro-level event.

In addition, several viewed the downside risks from weaker economic activity abroad as having diminished somewhat.

International economic news has become increasingly positive over the last few months. The EU's Markit numbers have slowly risen, while its GDP has been stronger than expected; the UK's news has been surprisingly strong; Canada is rebounding from an oil price-induced recession; recent Japanese news has been very encouraging; and Chinese hard landing hasn't materialized. Overall, the international economic background is slightly brighter.

But several indicated that they continued to be concerned about the downside risks to economic activity associated with the possibility of additional appreciation of the foreign exchange value of the dollar or financial vulnerabilities in some foreign economies, together with the proximity of the federal funds rate to the effective lower bound.

The U.S. dollar is near 5-year highs, which creates an unwanted revenue headwind for U.S.-based large multi-national companies. The Fed's publicly stated desire to raise rates this year adds further upward pressure to the dollar, especially as no other developed economy central bank is also raising rates.

However, while there is ample reason for the Fed to be cautious, there remain few reasons for it not to increase rates at least a 2 times this year. For an economy in its 8th year of expansion, with inflation approaching 2%, interest rates below 1% make little practical sense, if for no other reason than to give the Fed downside policy room when the next recession hits.

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