“It's the smart move. Tessio was always smarter.” — Michael Corleone
Last week, Federal Reserve presidents took to the airwaves and speaker lecterns with particular intensity to focus the markets on the potential for a policy rate hike this coming March 15. I found some of this rather odd, especially because just a week ago, it looked like a combination of mixed economic data, lack of direction regarding fiscal stimulus from the White House, and unsettling geopolitical risk had the markets firmly pricing in two Federal Open Market Committee Fed Funds hikes in 2017 as opposed to three. The odds of a March hike, as indicated by the Fed Funds Futures curve, was about 40% as of last Friday.
Then, over the weekend and into this week, one Fed president after another put a March hike firmly on the table. What I also found puzzling about the Fed's new stance was, while President Trump's much-anticipated speech to a joint session of Congress was widely considered a good one, details about a corporate and individual tax overhaul, massive infra-structure spending, and repeal and replacement of the Affordable Care Act were vague at best. Scant details in February probably mean a lack of actual fiscal stimulus for a good part of 2017.
Leading up to the President’s speech, I had thought if it contained some broad details on tax and spending policy, as Presidents Clinton, Bush, and Obama offered in their first addresses to Congress and the nation, we would have a sharp sell-off in bonds, particularly in the front end of the curve, where perhaps a faster removal of monetary stimulus would be in the offing to counter the addition of new fiscal stimulus. Conversely, if the President’s speech was light on details regarding the above-mentioned fiscal items, the front end of the rate curve would stay about where it was before the speech, with the 2-year around 1.15%. Instead, as stocks rallied strongly off the speech, Fed speakers seemed to double down on their efforts to put March on the table. The result is that the 2-year Treasury yield spiked 17 basis points to a rate of 1.31%, a rate that puts a very firm chance of three rate hikes in 2017, with the first coming in either March or May. Some of this rise in rates is, of course, related to the surge in stocks, but most is due to "Fed speak."
Why would the Fed upset the apple cart the way they have, particularly without a clear fiscal policy picture and February employment numbers being released ahead of their March 15 meeting? I think the Fed is using March as a sort of pre-emptive move to get ahead of possible fiscal stimulus coming from the White House in the spring. I predict it's more likely to be this summer because both the tax and spending policies that we think will come from the White House will have their share of resistance within the President's own party.
There will be plenty of difficult negotiations between the White House and Congressional leadership to enact legislation. In the end, if President Trump retains his popularity within his party, he has enough power to get a decent portion to go his way. At that point, if the Fed already has one Fed Funds hike in their pocket (and the market has absorbed it), they won't be seen as behind the curve in a mad dash to get three hikes done in the second half of the year. Additionally, two hikes as opposed to three after a fiscal stimulus package may reduce friction between the Fed and the President.
On the other hand, if the White House cannot get their agenda through, the Fed will be able to stay the course of gradual tightening and will already have one under their belt. Furthermore, if the lack of fiscal stimulus (or just the normal economic life cycle) leads to a slowdown in economic growth, the Fed will have been able to sneak in a tightening before the data ties their hands again like it did in 2015 and 2016. This will allow the Fed to take one or two tightenings back in the event of a recession.
A policy tightening in March is the smart move.
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