Fed View: A shift in tone rather than substance – Fed Chair Powell made headlines overnight with some strikingly hawkish comments, and coming alongside continued exceptional strength in macro data, and a further rise in oil prices, this drove 10y Treasury yields to the highest level since 2011. Expressing a remarkable degree of confidence in the economic outlook, he said ‘there’s really no reason to think that this cycle can’t continue for quite some time, effectively indefinitely.’ He furthermore suggested that the Fed ‘may go past neutral’ with its rate hikes, and that ‘we’re a long way from neutral at this point, probably.’
While this shift in tone is notable, and should be taken seriously, we highlight two important caveats. First, these comments were not part of prepared remarks, but rather were made ‘off the cuff’ at an event in Washington. Second, in substance, what Powell is saying about rate expectations relative to neutral is actually consistent with what the median ‘dots’ projections also indicate (i.e. we are still some way off the Fed’s view of neutral – 3.0% – and the Fed ultimately expects rates of 3.4% by 2020).
The September FOMC meeting was only last week, and this showed minimal changes in the 2019 rate hike projections. We think it unlikely Powell’s views over rate hikes have shifted so quickly. One possibility is that he might be ‘talking up’ the economy in order to assuage concerns that the Fed’s tightening of policy will induce a recession – which is what the yield curve flattening of late was beginning to point towards. The recent re-steepening, driven by a sharp rise in the 10y and a comparatively muted move in the 2y would suggest some success if this is indeed the objective of recent communications. This would also be consistent with the Fed’s recent attempt at de-emphasising the precision of neutral rate estimates, which Chair Powell and New York Fed President Williams believe markets have put too much weight on (and, reading between the lines, that this may be one of the reasons the yield curve flattened so much).
While the Fed currently expects a further five rate hikes by 2020, we believe it is likely that three rate hikes by next June will ultimately be deemed sufficient – taking the target range for the fed funds rate to 2.75-3.00%. We think growth momentum will show signs of cooling thereafter. Aside from fading fiscal stimulus, a probable turn in the investment cycle and other signs of tighter policy exerting a drag on economic growth are likely to become apparent. For instance, it is possible that higher mortgage rates are already having some dampening effect on housing, which has been notably soft of late (even Chicago Fed president Evans, who has been surprisingly hawkish recently, referred to this).
What does mean for Treasury yields? As noted earlier, something of a perfect storm of factors have pushed 10y yields higher in recent days. However, historically, the 10y does not peak much higher than the eventual peak in the fed funds rate, hence our year-end target of 3.10%. While it is possible that Powell’s hawkish rhetoric has some longer-lasting implications, we think the recent move could be a case of a technical overshooting, and yields move back lower in the coming weeks. (Bill Diviney & Nick Kounis)