Week ending Friday December 15th 2017
An apparently stupid question in our header this week. But the answer will be surprising to many. The Fed raised its target rate 25bps on Wednesday but rates, rates in the sense of those that matter, market rates, fell slightly. Bond yields across all maturities above 12m fell on the announcement. The Fed action actually made “rates” fall. Asimilar phenomenon was seen in November in the UK on the most recent Bank of England rate “rise”.
The bond market was saying that the Fed has moved too far too fast, saying it doesn’t believe that there will be three more rate rises in 2018 and three in 2019 and now one more in 2020, taking the 2020 projection above the long run projection even. It is a fantasy land built on the fantasy Phillips Curve – that employment drives inflation.
Bond markets think monetary policy is now so tight that policy rate cuts may soon be likely. They look particularly at the inflation rate which is staying low, keeping a lid on nominal growth – and is actually going lower.
The yield curve flattened more with the 10yr less 2yr spread dropping back to the post-recession lows of 51bps. The USD remained flat over the week. Lower expected nominal growth leading to lower rates than expected will lead to a weaker USD – despite those near term rises in policy rates.
US equities seem very happy hitting new highs. But it is hard to tell how much of this is due to better expectations for underlying growth versus expected higher net profits thanks to lower corporate tax rates. The picture here is very muddy as a result of the noise from the tax reforms.
A robust November in actual data
Apart from the FOMC meeting there was a large amount of data released during the week. The November Industrial Production figure itself was a bit disappointing but upward revisions of earlier data confirmed that growth was at is healthiest since the start of the tightening cycle back in 2014. This is a bit surprising if monetary policy was too tight, but the Trump bounce does appear real for now in the current data.
November Retail Sales also showed a strong bounce from the mid-2017 weather-related dip and seemed to show a good upward momentum. While we know that Retail Sales like NGDP itself is still well below trend, it is better to be moving up in growth rates rather than lower. Earlier in the week, the November NFIB Small Business Optimism Index also bounced back from some recent lulls, and they are quite a sceptical bunch. The one negative reading from the week was for a survey of December, the first reading from Markit’s PMI for the Services Sector.
We still don’t know whether the new Fed will allow this good news to continue and begin to move current levels of activity back towards the longer term trend. Janet Yellen said at her last press conference that her only failure was not to have inflation back to 2%. But the big failure she missed: getting real and nominal growth back to the levels they should be at. The cause is her views and those of the Fed’s obsession with inflation – that also meant they were doomed to miss their inflation target too.
Heading into the Christmas break there is some flow of data for November as well as more surveys for December. The bigger news will be the final shape of the GOP tax package and the market’s response to it. The latter seems more or less baked in to prices given the huge volume of information on the negotiations flowing out of DC. The lack of benefits flowing to the middle classes could be a problem for confidence and activity even if business seems to be doing well.