The odds of additional interest-rate increases by the end of the year have been falling significantly. In fact, there is currently a 24% chance that there will be NO MORE rate hikes this year, according to Bloomberg (which uses Fed Funds futures to determine the probabilities). On April 7th, the odds of no additional hikes this year were only around 10%. The increased odds of the Fed staying on the sidelines through year-end reflect the following:
- There continues to be a wide gap between the “soft” economic data, which is generally based on surveys, and the “hard” economic data, which reflects real economic activity. Recent weak economic data include:
- Job growth in March was well below expectations (although the unemployment rate fell to a low 4.5%);
- Retail sales in March were weak (reflecting, in part, a delay in tax refunds);
- Wage growth in March was positive, but remains lackluster after adjusting for inflation;
- Housing starts were well below expectations;
- Manufacturing production contracted in March;
- Auto sales were disappointing and appear to have peaked for this cycle; and
- The lackluster economic indicators we have noted are causing economists to lower their 1Q GDP growth forecasts to as low as +0.5% (Federal Reserve Bank of Atlanta)
- The most recent readings for both the Consumer Price Index (CPI) and the Producer Price Index (PPI) suggest that inflation is not accelerating;
- The failure to pass a new health care bill, which has been interpreted to mean that the odds of tax cuts and infrastructure spending this year have decreased;
- Potential fallout from Brexit and the French elections, which has caused yields on UK Gilts and German Bunds to drop on a flight-to-safety trade;
- Additional geopolitical uncertainty created by the US bombing of regime assets in Syria and the threats posed by North Korea;
- Strengthening in the dollar over the past six months, which acts as a headwind on exports and GDP growth while negatively affecting earnings at US multi-national corporations;
- Recent weakness in loan demand being reported by many banks this earnings season; and
- Protectionist trade rhetoric coming from the Trump administration, which could result in lower exports if enacted.
The chart below shows that the odds of zero additional Fed interest-rate hikes by year end have increased to 24% from 10%. The odds of only one more hike have increased to 41% from 34%, and so on.
What do we think? For now, it appears that neither economic growth nor inflation are on a path toward significant acceleration. As a result, we think the Fed could stand pat for the rest of the year (leave interest rates unchanged) with one vital caveat. The caveat is that Congress continues to make little progress toward implementing any of the “pro-growth” initiatives that the new presidential administration has been championing. If this remains that case, we think the bond market will remain well-bid, reflecting continued ~2% economic growth, low inflation expectations, and ongoing geopolitical uncertainty. The economy has been unable to break out of its current 2% growth trend despite 8+ years of near-zero interest rates, a plunge in energy prices, and a 250% increase in stock prices. Absent sizable fiscal stimulus, we see little reason why the economy will reach escape velocity now that interest rates and energy prices have bounced off the lows. The economy simply continues to be saddled by too much debt, too much economic inequality, and rampant unpreparedness for retirement (which could cause savings rates to continue rising). Therefore, we don’t think the economy can withstand significantly higher interest rates. The bond market has made the adjustment. Will the stock market follow suit?
*Source: Bloomberg (FF in the graph signifies the Fed Funds Rate, which the Fed alters in the course of monetary policy).
The graph above shows that even as the Fed has raised interest rates (and continues to signal more to come), yields on Treasury bonds have come down over the past couple of weeks. Not only is this bad for banks (who generally make money by borrowing short and lending long), but it can also be a sign of: 1) a slowdown in economic growth; or 2) a reduction in inflation expectations, which could be the result of slower economic growth. While there are clearly other influential factors, the bond market seems to be sending a different signal than the stock market. Which will prevail?