The primary economic theme in recent weeks has been inflation, or the lack thereof. In particular, core inflation has disappointed, surprising to the downside for the past two months. This weakness in consumer prices has been a headwind to the global reflation trade that took hold of the market back in August 2016. Additionally, growth in nonfarm payrolls, the most dependable economic metric of the last several years slowed in recent months. While the headline unemployment rate fell to a 17-year low of 4.3% in May, payrolls growth was slower than expected, and there was a 66,000-downward revision to the prior two months. Consequently, the three-month average of payrolls growth slipped to 121,000. Given the corresponding drop in the unemployment rate, some are attributing the weaker jobs growth to a shortage of qualified labor; but the lack of significant wage inflation casts at least some doubt on that theory.
News from the political front has not helped either, with increased talks of links between the Trump administration and Russia, which culminated in the appointment of former FBI Director Robert Mueller as special counsel for the investigation. However, this appointment could serve as a positive for the market if the political focus shifts back to the legislative process, particularly tax reform. Additionally, in terms of actual policymaking, the House of Representatives passed a revised version of its new healthcare bill that now awaits passage by the Senate, which will likely include many additional revisions.
Across the globe, missile tests by North Korea and increased activity by ISIS have spooked the markets, pushing investors to seek safe harbor in U.S. Treasuries and driving rates down. In the UK, recent polls suggested that the Conservative lead over the Labour party shrunk, which increases the likelihood that the current ruling party will not have the majority going into Brexit negotiations.
Given the weakness in inflation and the disappointing initial estimate of Q1 GDP, the market was interested in how the Fed would interpret this data, as well as how it would affect the timing of the central bank’s balance-sheet reduction. The official statement of the May 3 FOMC meeting acknowledged the aforementioned weakness, but it was largely dismissed as transitory. Furthermore, there were no changes to the guidance for QE reinvestments, suggesting the Fed was not ready to officially discuss balance-sheet reduction. However, the May minutes revealed more information regarding the latter.
FOMC participants suggested they would start shrinking the Fed’s securities portfolio this year, “as long as the economy and the path of the federal funds rate evolved as currently expected.” Further, the Fed staff proposed a few general guidelines for the process of reinvestment tapering from an operational perspective. The plan would call for the Fed to announce a set of gradually increasing caps (or limits) on portfolio reduction, with any amount of principal paydowns in excess of the cap reinvested. While no specific figures were discussed, the caps would initially be set at low levels and raised every three months until reaching their fully phased-in levels. The minutes revealed that “nearly all policymakers” were in favor of this general framework because it would be consistent with the FOMC’s intention to reduce the Fed’s holdings, “in a gradual and predictable manner.” The financial markets responded favorably to this revelation, as it somewhat lessened investor concerns of a more disruptive impact on MBS and Treasuries once the process is initiated. This idea, however, does raise some issues. First, the market will inevitably take a view on paydowns (i.e., prepayments and maturities). Secondly, any changes in the caps would signal a change in the policy rate level.
A June rate hike is all but priced in, although the May jobs report dampened the confidence of market speculators and forecasters. In order for the Fed to tighten again in September and proceed with balance-sheet reduction, the overall data trend, particularly inflation data, will likely have to improve.
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