The Federal Reserve continued to press ahead yesterday with its public relations effort of talking up the possibility of a rate hike, perhaps as early as next month. The latest addition to the hawkish-chattering club is the Philly Fed’s Pat Harker, who advised on Monday that “I can easily see the possibility of two or three rate hikes over the remainder of the year.” The comment follows similar remarks from central bankers in recent days, including New York Fed Bill Dudley’s observation that “if I’m convinced that my own forecast is on track, then I think a tightening in the summer, the June-July time frame, is a reasonable expectation.”
The market reaction, however, is mixed. The 2-year yield—considered the most sensitive spot on the yield curve for rate expectations—is moving higher. This maturity ticked up to 0.91% yesterday (May 23), based on daily data via Treasury.gov. That’s the highest rate for the 2-year since mid-March. But the benchmark 10-year yield, which is more sensitive to inflation expectations, has a downside bias these days, settling at 1.84% yesterday—well below the peak for the last two months.
Speaking of inflation expectations, they’re trending lower again, by way of the implied forecasts via spreads in nominal less inflation-indexed Treasuries. The downside bias is especially conspicuous in the 10-year breakeven rate, which eased to 1.54% yesterday, the lowest since mid-March. Note, too, that the softer inflation estimate is accompanied by a stock market that’s drifting lower this month. That’s not terribly surprising at this late date. The tight correlation between the S&P 500 and the implied inflation forecast via 10-year yields endures. The fact that both are ticking down again suggests that the Fed chatter about squeezing monetary policy is casting a disinflationary effect across markets. That’s not exactly productive at a time when doubts persist about the near-term prospects for economic growth.
As Tim Duy notes, the Fed’s hawkish tone over the last week or so is “curious.” The economist and veteran Fed observer notes:
The basic argument for rate hikes is that the economy, and in particular the labor market, sustained its momentum in the last two quarters better than market participants believe. Given that the economy is near or beyond full employment, the lack of excess slack will soon manifest itself in the form of inflationary pressures. Hence, to remain ahead of the inflation curve and maximize the chance that rate hikes will be gradual, they need to soon raise rates.
But the argument that employment and inflation trends warrant more tightening soon is “hasty,” Duy concludes. “I think this narrative rang true through last summer. But, by my read of the data, since then progress toward full employment has stalled.”
The Treasury market seems to agree, at least by way of the 10-year yield and its breakeven rate. The burning question: Will this market-based forecast of inflation continue to fall? If the answer is “yes,” it’s likely that the S&P 500 will move lower as well.
Optimists can still point to a firmer growth forecast for second-quarter GDP. The Atlanta Fed’s May 17 nowcast calls for a rebound in Q2—GDP is projected to rise by 2.5%, which is well above the virtually flat 0.5% rise in Q1.
But the early signals for the May macro profile are weak, albeit based on the view via manufacturing. Survey data published by Markit Economics yesterday reveal that manufacturing output fell for the first time since 2009. “The weak manufacturing PMI data cast doubt on the ability of the US economy to rebound from its disappointing start to the year in the second quarter,” says Chris Williamson, Markit’s chief economist.
Manufacturing is only one slice of US economic activity, of course. A more reliable clue about the broad macro trend arrives tomorrow (Wednesday) with the May survey data for the services sector. The numbers on this front point to a firmer trend: Markit’s Services PMI reflected stronger growth in April, although growth remains subdued relative to recent history. In any case, if the Services PMI stumbles in the flash data for May, the Fed’s argument for a rate hike sooner rather than later will suffer. In that case, expect even lower numbers for the Treasury market’s inflation forecast and the S&P 500.