U.S. Bond Market Week In Review: Rate Hikes Are Still On For 2018

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by: Hale Stewart

On Wednesday, the Federal Reserve released the latest Meeting Minutes, which were taken during December's meeting. The Fed believes that financing conditions are supportive, and that the economy ended the year on a high note. However, there are still a large number of conflicting views among the Fed governors regarding inflation, indicating there is no consensus about the cause of still low rates.

The Minutes offered the following general assessment of the financial markets:

Movements in domestic financial asset prices over the intermeeting period reflected slightly stronger-than-expected economic data releases, announcements related to Treasury debt issuance, and an increase in the perceived probability that the Congress would enact tax legislation. On net, the Treasury yield curve flattened, U.S. equity prices moved up, and the foreign exchange value of the dollar was little changed. Financing conditions for businesses and households remained broadly supportive of continued growth in household spending and business investment.

This still remains generally true; however, there have been recent spikes in the short-term asset-backed and commercial paper market:

Above are three charts for the short-term asset-backed market. Over the last month, we've seen increased spreads. The overnight market (top chart) is a bit higher. But the 30-day spread (middle chart) and 90-day spread (bottom chart) have both spiked pretty sharply.

We're also seeing increased spreads in the short-term commercial paper market.

Previous spikes coincide with the decrease in oil prices, when short-term funding dried up for oil drillers. I haven't seen any explanation for the current increases, which aren't fatal but should be watched.

The Fed was bullish on the economy:

Real economic activity appeared to be growing at a solid pace, buttressed by gains in consumer and business spending, supportive financial conditions, and an improving global economy. Participants judged that hurricane-related disruptions and rebuilding had affected economic activity, employment, and inflation in recent months but had not materially altered the outlook for the national economy. They saw the incoming information on spending and the labor market as consistent with continued above-trend growth and a further strengthening in labor market conditions. Consequently, participants continued to expect that, with gradual adjustments in the stance of monetary policy, economic activity would expand at a moderate pace and labor market conditions would remain strong. Inflation on a 12-month basis was expected to remain somewhat below 2 percent in the near term but to stabilize around the Committee's 2 percent objective over the medium term. Near-term risks to the economic outlook appeared to be roughly balanced, but participants agreed that it would be important to continue to monitor inflation developments closely.

This is consistent with the data.

The Fed is still deeply divided about inflation. The majority still view it as a transitory development: Many indicated that they expected cyclical pressures associated with a tightening labor market to show through to higher inflation over the medium term. These participants generally judged that much of the softness in core inflation this year reflected transitory factors, and that inflation would begin to rise as the influence of these factors waned. This is based on the Fed's macro-economic model, which includes the Phillip's Curve. Despite ample research that states the curve is far flatter during this expansion, the Fed continues to believe it is much steeper.

Not all participants are on board: "However, one of them noted that secular trends, such as technological innovation or globalization, could be affecting competition and business pricing, and muting inflationary pressures." These are the two most-cited theories regarding weak inflation. "Technological innovation" is more commonly referred to as the "Amazon effect." Thanks to the internet, consumers can search prices in real time, limiting retailers' ability to raise prices. "Globalization" means that supply is now global. There are a number of reasons why this keeps prices low, including an increased number of suppliers, currency issues and products being manufactured in countries with lower standards of living.

Several presidents are concerned about the potential negative impact on inflation expectations. Several of them expressed concern that persistently weak inflation may have led to a decline in longer-term inflation expectations; they pointed to low market-based measures of inflation compensation, declines in some survey measures of inflation expectations, or evidence from statistical models suggesting that the underlying trend in inflation had fallen in recent years. While others disagreed with this assessment, a look at the data indicates the concern is well-founded:

The above charts show that longer term, inflation expectations have declined.

All of this stands in contrast to the October Minutes, where it appeared the Board was moving towards a common understanding that structural issues were keeping inflation low:

Many participants continued to believe that the cyclical pressures associated with a tightening labor market or an economy operating above its potential were likely to show through to higher inflation over the medium term. In addition, many judged that at least part of the softening in inflation this year was the result of idiosyncratic or one-time factors, and, thus, their effects were likely to fade over time. However, other developments, such as the effects of earlier changes to government health-care programs that had been holding down health-care costs, might continue to do so for some time. Some participants discussed the possibility that secular trends, such as the influence of technological innovations on competition and business pricing, also might have been muting inflationary pressures and could be intensifying. It was noted that other advanced economies were also experiencing low inflation, which might suggest that common global factors could be contributing to persistence of below-target inflation in the United States and abroad. Several participants commented on the importance of longer-run inflation expectations to the outlook for a return of inflation to 2 percent. A number of indicators of inflation expectations, including survey statistics and estimates derived from financial market data, were generally viewed as indicating that longer-run inflation expectations remained reasonably stable, although a few participants saw some of these measures as low or slipping.

While the above paragraph contains the standard "we think inflation will rise in the intermediate term" language, there is also a not inconsequential discussion of structural reasons causing weak inflation. There is also an acknowledgment that weak price pressures are global in nature, which adds a great deal of weight to the structural causation argument.

Once again, it now appears that we're back to a majority of the Fed (once again) arguing that inflation will return to 2% in the intermediate term. This despite the fact that they have been arguing for this development for the last few years, to little or no avail.

Hale Stewart, XE.com