As the 10-year Treasury yield flirts with the 4% level and the yield curve steepens from its inverted condition, it’s worthwhile to keep in mind that the universe is unfolding as it should. Monetary conditions are tight, inflation is moderating, the jobs market, though tight, is weakening, and the economy is chugging along with no signs of a recession. Various Fed speakers have cautioned that while the inflation fight isn’t finished, the hiking cycle is over and the next likely interest rate move is down.
These conditions argue for a bull steepening of the yield curve, where bond yields fall while the curve steepens, and a conducive environment for stock prices. Why fight the Fed and the macro trend?
A dovish macro backdrop
Make no mistake, conditions are ripe for rate cuts, but in a good way. The Fed has engineered a skillful tightening cycle. The Fed Funds rate is well above the inflation rate. Falling inflation has done the heavy lifting in monetary tightening. As CPI falls, the real Fed Funds rate rises. At some point in the near future, the nominal Fed Funds rate will have to fall in order to avoid overtightening.
In addition, inflation data is trending in the right direction toward the Fed’s 2% target. December headline CPI came in ahead of expectations, but core CPI was in line. Even though core CPI rose 0.3%, only 42% of the CPI basket saw monthly gains of 0.2% or more. The combination of the CPI and tamer-than-expected PPI translates into the Fed’s preferred inflation metric of core PCE of 0.2% in December, which smooths the path to rate cuts.
Moreover, the New York Fed’s survey of consumer inflation expectations is back to pre-pandemic levels. One-year inflation is expected to rise 3.0, and 2.6% over three years, compared to 5% and 3%, respectively, one year ago.
The employment situation has seen frequent negative revisions to past nonfarm payroll releases. This is an indication of a jobs market that’s weaker beneath the surface.
A dovish Fed
As a consequence of the friendly inflation environment, Fed speakers have become increasingly dovish.
Fed Governor Michelle Bowman, who is regarded as a hawk, said that in a speech that her “view has evolved to consider the possibility that the rate of inflation could decline further with the policy rate held at the current level for some time. Should inflation continue to fall closer to our 2 percent goal over time, it will eventually become appropriate to begin the process of lowering our policy rate to prevent policy from becoming overly restrictive.”
New York Fed President John Williams used his now familiar metaphor of an onion to describe inflation in a recent speech
. Inflation has three layers. The first represents globally traded commodities, which “have come down significantly from their peak levels” after the pandemic and Russo-Ukraine war related disruptions. The second layer is core goods, or goods ex-food and energy, whose inflation rate has “dropped to nearly zero”. The third and last layer, core services inflation, “has come down after peaking early last year”. Equally important is the progress on core services excluding housing inflation, which “has also slowed considerably”. He concluded that “it will only be appropriate to dial back the degree of policy restraint when we are confident that inflation is moving toward 2 percent on a sustained basis”.
Dallas Fed President Lorie Logan
took a more hawkish note by expressing concern about markets getting ahead of the Fed on rate cut expectations: “We can’t count on sustaining price stability if we don’t maintain sufficiently restrictive financial conditions.”
However, she sounded a word of warning about the liquidity plumbing of the banking system as the overnight reverse repo account ON RPP falls rapidly [emphasis added].
Given the rapid decline of the ON RRP, I think it’s appropriate to consider the parameters that will guide a decision to slow the runoff of our assets. In my view, we should slow the pace of run-off as ON RRP balances approach a low level. Normalizing the balance sheet more slowly can actually help get to a more efficient balance sheet in the long run by smoothing redistribution and reducing the likelihood that we’d have to stop prematurely.
As a reminder, banking system liquidity is approximated the size of the Fed’s balance sheet – ON RRP – the Treasury General Account. All else being equal, a falling ON RRP increases banking liquidity. If ON RRP falls to zero, Logan is proposing tapering quantitative tightening, or the reduction in the Fed’s balance sheet, to compensate. QT is turning into QE. Logan’s words about the Fed’s balance sheet carries extra weight as she was the former head of the New York Fed’s trading desk. In the wake of Logan’s speech, market expectations are building that the Fed will begin to taper QT mid-year.The Fed is turning dovish. The market continues to expect a rate cut at the March FOMC meeting. The Fed hates surprising the markets. Unless Fed speakers push back strongly against the notion of a March rate cut and expectations of a cut stay above the 60–65% level, a March cut will be a done deal.
Don’t fight the Fed and the macro trend.
Key risk: Transitory disinflation
However, I continue to be concerned about the risk of transitory disinflation to the dovish Fed scenario. The New York Fed’s Global Supply Chain Pressure Index is rising again, indicating that progress in goods inflation is over. Is this just normalization or something more ominous?
Red Sea related disruptions are showing up in global shipping costs. While readings are nowhere near pandemic levels, it’s a lesson how global shocks can disrupt progress on inflation.
The Atlanta Fed’s wage growth tracker came in at 5.2% in December – and it’s been stuck at that level for three consecutive months. Even though there is growing evidence of a cooling jobs market, wage pressures aren’t falling.
In conclusion, the global disinflation trend is continuing in an uneven manner and both the macro trend and Fed speakers are pointing toward a dovish Fed pivot. This argues for a bull steepening of the yield curve and a bullish backdrop for stock prices. However, investors should be aware that the lurking risk is the re-emergence of the transitory disinflation narrative, which could derail the bullish scenario.