Soft data ? What soft data ? ..... The Fed's coming across a bit "Gung-ho" for some tastes.

Friday 16th June 2017

Soft data ? What soft data ? ..... The Fed's coming across a bit "Gung-ho" for some tastes.

ref :- "Investors Fear Policy Misstep by the Fed" , The Wall Street Journal

It certainly makes a change, though whether it's a welcome one or not would depend entirely upon your point of view. When it comes to monetary policy and the path for interest rates, there are always a number of perfectly legitimate positions one might adopt .... at least three, anyway : Tighten, Hold Steady, or Relax. In any debate, the camp not getting their way tends to be the more vociferous but in the area of Central Bank monetary policy we suspect that those who have been calling for a less cautious, more aggressive approach in recent years would probably be the noisier types anyway.

For example, German financiers and politicians with an eye for strictly German interests rather than those of the broader Eurozone rarely miss an opportunity to rail against the ECB's ultra-easy policy and the pain it inflicts on savers and banks. And in the US President Trump has been making his disdain (contempt ?) for Janet Yellen and the Fed's cautious approach to rate rises very clear ever since ..... well, since he was a mere candidate.

Even Mr Trump might struggle to make that argument right now, however. Anybody might, for that matter, if an open mind and a belief in some generally-accepted market principles formed any part of their thinking (yes, yes ..... we know !) . The fact is that if this week's 1/4 point hike by the Fed was entirely expected, their assertion that recent soft inflation data is a temporary blip (and therefore their intended path for further rate hikes should remain unaltered) has got a few worried that they may be assuming too much.

Concerns that the future for the economy may not be as robust as expected are showing up in the bond markets. The yield curve, as evidenced by the yield premium that investors require to buy 10yr Treasury bonds over their 2yr equivalents, is flattening. At 80 basis points, it's the smallest (and therefore the curve is at its flattest) since last September, and it's approaching levels last seen in 2007. Some accepted wisdoms may be under review, but it's still very much the case that a flattening yield curve is seen as a typical sign of economic momentum slowing.

More than anything, it's the inflation factor that's got them thinking. Fed Chairwoman Janet Yellen was able to shrug off another inflation report below expectations and drifting further from the 2% target in the belief that the very strong employment scenario will soon bring it back into line. Bond markets are not so sure. Because inflation eats into future fixed returns, bond dealers are particularly sensitive to all matters inflationary so they're worth listening to, and one of the inflation measures they pay most attention to would not seem to support the Fed line. The 10 year break-even rate measures the yield on a 10yr Treasury bond MINUS the yield on a 10yr inflation-protected equivalent (a TIPS). At 1.71 %, it's at its lowest since October and headed in the wrong direction as far as Fed expectations are concerned, both for inflation and by extension for the economy.

It's not something we've been used to of late but prompted by these moves in gauges that might seem a little obscure to the average Joe, the accusation in some quarters is that the Fed is implementing rate hikes unnecessarily with inflation falling. One of the arguments for erring on the side of being cautious in their approach is that falling expectations of inflation can be very tough to reverse. To some extent, they can be self-fulfilling. Consumers and businesses can delay spending plans with obvious repercussions for the business cycle and for inflation itself. 

Any scenario that sees the Fed "tightening into a slowdown", as Charlie McElligott of RBC put it, is unlikely to end well. It may be the bond markets who are flagging up warning signals, and they would have to deal with more suppressed yields and high prices, but it's a stock market already at stretched valuations that may have most to fear from the Fed misreading the situation. Whether they do so or not may hinge on whether they're right to maintain faith in the tried and trusted theory that low levels of headline unemployment automatically translate into upward pressure on inflation (the Phillips Curve), or whether changing work practices and demographics have made such a simple formula redundant.

It may sound like a question of largely academic interest, but the effects of the Fed getting it wrong would be very real indeed.