It’s Still All About The Fed

A lot has been packed into a short week but, despite all the political posturing and rhetoric surrounding trade tariffs, it is still central bank policy that ultimately drives market sentiment and this week we have seen key inputs from leading players at the most important central bank of all, the US Federal Reserve, that have been somewhat overshadowed by more sensationalist news from the political arena.

Almost unnoticed was the announcement that John Williams, the current San Francisco Fed Governor, is to replace William Dudley, who is retiring as head of the NY Fed on the 17th June. This is a key decision as, along with 7 members of the Board of Governors of the Federal Reserve System, it is the only permanent voting position on the FOMC. For Fed observers this is significant news as Dudley was a well-known dove whereas Williams has changed in recent years from ‘dovish’ to more neutral and a supporter of all recent hikes, in which he cited the strength of the labour market to support the action. In addition Williams is also thought to favour changing the Fed mandate from a hard 2% inflation target, that was set 6 years ago, to a price level target range which would give the Fed more flexibility on monetary policy but also take away a degree of certainty that markets currently enjoy. The voting members of the FOMC were generally more dovish in 2016/17 and this latest change merely adds to the general bias drifting towards a more neutral/hawkish leaning, which might just tip the dot plot chart from its current 3 hikes in 2018 to 4, as the year progresses.

Also this week we have heard from two key fed participants. Neel Kashkari (President of the Minneapolis Fed & alternate member 2019) was speaking at the Regional Economic Indicators Forum and cemented his position as the most dovish of the current voting FOMC members when he commented that while US tax cuts have clearly lifted enthusiasm among businesses, it is still unclear if the cuts are actually going to lead to more investments and “we are close to neutral (rates) right now”. Lael Brainard was speaking at the Stern School of Business in NY where she came across more neutral than her normal dovish persuasion. Particularly relevant was her observation that recent US fiscal stimulus and other economic tailwinds create a backdrop that “warrant a gradual increase in rates” and that “valuations in a broad set of markets appear elevated relative to historic norms”, although she did caveat this with her opinion that “despite elevated asset valuations overall risk to the financial system remain moderate” – which is something we have recently commented on.

These comments from prominent FOMC members emphasise the importance of this Friday’s Non-Farm Payroll number and, maybe even more importantly, the Labour Participation Rate. In February the participation rate was 63.0% (which is bang-on the average rate since 1950!). The rate has been relatively stable for the past few years but Fed members have been paying more attention for signs of a move in the trend, particularly where the ratio of employed vs seeking employment changes, as this will indicate if pressure is building for higher wage inflation; and therefore a need for further rate hikes.

We have seen increased volatility in US treasuries over the past couple of months accompanied by a recent flattening of the curve. Some of these moves have been driven by technical factors and some have been driven by a classic flight to a safety haven. It doesn’t seem the volatility is going to disappear anytime soon hence maintaining relatively short duration may be the more prudent stance while we are in this this transitional period.