All indications are that the next move the Federal Reserve makes will be a rate cut. As recently as the end of last year, the thought was totally anathema. There would be rate hikes in 2019, the general consensus was, and it was just a question of how many. But that narrative is quickly being thrown out the window.
One major indication comes from the former Fed Chair herself, Janet Yellen, who actually admitted, publicly that the next move the Fed makes may indeed be a cut. She provisioned that opinion on weakened economic growth of course, but keep in mind that as late as early January the Fed was saying that at many as 2 rate hikes were on the table for 2019. By the end of January, it was down to zero.
Now it’s not just Janet Yellen. Federal funds futures traders are actually saying that a cut all the way down to 1.5% on the fed funds rate is more likely at 0.2% than a hike to 2.5% (0% chance) by 2020. That’s just an academic point, but more importantly the chances of a cut to 2% is 19.9% by year end and nearly 30% by 2020 whereas the chances of a hike to 2.5% are zero all the way through. Below is a screenshot from the probability table sourced from federal funds rate futures prices by the CME Group. To see the full table, click on Probabilites at the link above. (Data change quickly and may have changed since time of writing. The screenshot below is from February 11.)
Source: CME Group
Before any rate cut is implemented however, the Fed will most likely try other moves first, first and foremost a cessation of the reduction of its balance sheet. The Kansas City Fed just released a report on its website to this effect that on the face of it questions the economic law of supply and demand. Its title? “Do Changes in Reserve Balances Still Influence the Federal Funds Rate?” Well, if reserve balances are the supply of reserves and the federal funds rate is the price of loaning those reserves, then the question really is, Does supply affect price? Yup. It does.
For some odd reason though it took Andrew Lee Smith, the author of this report, 30 pages of tortured econometrics to figure out that yes, supply does in fact affect price, thereby reinventing the economic wheel.
Smith’s conclusion should scare anyone who assumes the Fed knows what it is doing, rather than learning on the fly. It reads as follows ( emphasis mine):
The recent rise in the federal funds rate relative to the IOR rate has raised questions about the primary drivers of the federal funds-IOR spread in the Fed’s new operating framework. Although substantial excess reserves in the banking system and the payment of interest on reserves have weakened the liquidity effect in absolute terms, a range of estimation strategies reveals that some linkages remain between the quantity of reserves and the funds rate…As reserve balances decline, the federal funds rate may continue to move modestly higher against the IOR rate. Such a rise could necessitate further implementation adjustments as policymakers continue to learn about the drivers of the federal funds rate in the Fed’s new operating framework.
As per the bold here, the fed admits it is, in fact, learning on the fly. Yikes.
I believe we can safely assume from here that the fed funds rate will not be hiked in the foreseeable future unless price inflation becomes an obvious issue. On the inflation front, I’m seeing more press denying that it is a problem. Marketwatch, an arm of the Wall Street journal, published a piece today, February 11, entitled “Inflation? What Inflation” which basically says there is no indication of accelerating price inflation in 2019 other than rising wages.
Here’s why I think that’s wrong and why we may indeed have an upside surprise by April or May. I’ve said in a previous article that inflation is likely to move higher by this quarter. My reasons were as follows. First, more tariffs would kick in against Chinese imports. Second, the European Central Bank would end its bond buying program, pushing the euro higher against the dollar on foreign exchange. Third, Q1 is the strongest for price inflation gains seasonally anyway.
As for the first reason, there is no progress on a China/US trade deal and no meeting will take place between President Trump and China’s Xi Jinping before the March 1 st deadline when tariffs are scheduled be raised to 25% from the current 10%. CNBC cites the Wall Street Journal which says that the two sides are so far apart that nothing has even been put in writing, and we are little more than 2 weeks away. If tariff rates go up to 25%, the effect on consumer prices will be noticeable. The supply of goods will be imported Chinese products will be constricted and that will raise consumer prices. (And I didn’t even need 30 pages of econometrics to know that supply affects price.)
As for the ECB, it did stop its bond buying program and the dollar index is down about 1% since December 12 th when the program officially ended. Not much admittedly, but no-deal Brexit tensions look to be keeping the dollar up for now as forex traders are very edgy on the Euro due to British parliamentary deadlock. Those tensions look likely to abate soon, as a new deal is being cooked up in parliament to back British Prime Minister Theresa May’s Brexit deal on the condition of it going to a second referendum, and this initiative appears to finally have some cross party support. If it passes, then the British people will chose to either accept May’s soft Brexit deal, or remain in the EU. Either outcome is bullish for the Euro (bearish for the dollar) since it would place some much needed certainty around the economic arrangements between the UK and the EU.
Even if this deal doesn’t pass, a Hard Brexit is very unlikely. Nobody wants it, no business, not the vast majority of the British People, and not its politicians either. They’ll all be blamed if it happens and it won’t be good for anybody, which means that Brexit will be delayed in the worst case scenario, and doubts will creep in as to whether it will ever happen.That will push the Euro up higher against the dollar.
As for inflation measures, the Fed’s preferred measure of price inflation, the personal consumption expenditures data for December from the Bureau of Economic Analysis, is late due to the last government shutdown, but the next one comes out March 1st. I don’t believe that there will be a significant upside surprise until the April report for March, but some analysts are already seeing some serious movement on the commodity front as it is. One Wells Fargo analyst in particular is seeing something unusual. John LaForge, head of real asset strategy at the bank, says the following:
Virtually all commodity prices rose last month. The largest gains were in the oil patch; West Texas Intermediate (NYSE:WTI) +20%, Brent +15%, and heating oil +13%. 3 But the commodity rally has been broad. Nearly all precious metals, industrial metals, and foodstuffs were up too. Is this normal? The answer is no.
LaForge doesn’t see this as a sign of inflation though. At least he doesn’t mention the word “inflation” in his blurb, but if this movement is happening already while the global economy is cooling off, then higher tariffs and a clean Brexit should help accelerate it, especially given that both will take effect around the seasonal peak in price inflation data.
Tying this together then, if by March/April we have a clean Brexit and higher euro and higher tariffs against China, all of which seem likely, price inflation could jump higher very quickly. The Fed stopping its balance sheet reduction program around the same time would be another big negative for the dollar at the wrong time. Price inflation as measured by government statistics could edge close to 3%, and investors could start getting nervous given that rate hikes are off the table. The Fed could soon be in a situation where it has to raise rates because of inflation but can't. Gold and other commodities could start a long overdue run in that case.
Disclosure: I am/we are long DBC, GLD. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.