The Federal Reserve has been criticized for being too dovish for too long. It is the market is more dovish than the market. Yesterday, the Fed stuck to its call. The median forecast still looks for another hike this year and three next year. The market does not believe it.
The December 2018 Fed funds futures contract implies a yield of 1.50%. The current target is 1.00%-1.25%. The US two-year note is yielding 1.36%. It peaked on the Ides of March just shy of 1.4%.
Some market participants wonder, how the Fed can raise rates when the economy is so slow and when inflation is falling. Judging from official comments, the FOMC statement, and Yellen’s press conference, the Fed sees things differently.
The Fed may prefer stronger growth, but it does not target GDP, and it accepts what some market participants do not: namely, that trend growth has slowed, and it cannot be addressed by monetary policy tool. The Fed thinks trend growth is 1.8%-2.0%. Growth in the first half is likely to be near-trend, with Q1 below and Q2 above. Trend growth has slowed from before the crisis. An influence Fed research paper suggests that around three-quarters of the decline in trend growth can be explained by demographics.
Also, the GDP measure is a useful snapshot of economic activity, but for the central bank’s purposes, it may be preferable to look at the components that monetary policy can influence. Many officials seem to prefer final domestic demand, which excludes net exports and inventories. That measure is more stable and stronger than overall GDP. Over the past four quarters, it has averaged 2.35% compared with 2.0% of GDP. Over the past two years, final domestic demand has risen 2.3% compared with 1.8% of GDP. It has averaged 2.43% over the past four years, while GDP has grown by an average of 2.2%.
Many observers also do not appreciate the transition in Fed thinking that we highlighted a few months ago. It is not longer data dependent in the sense that it does not need each piece of high frequency data to confirm the expansion is intact. The Fed’s confidence in the resiliency of the US economy has grown. It is data dependent in the sense now that it is confident of the expansion, it is looking for opportunities to normalize monetary policy.
This is not simply a case of raising rates to be able to cut them later. It is a question of prudent monetary policy. Yellen was explicit about this in the past and again yesterday. Gradual hikes now can prevent the need for dramatic and potentially destabilizing hikes later. It is prudent to remove monetary accommodation that was put in place when the economy was in grave danger.
The Dollar Index has bounced from yesterday’s spike low to 96.32, its lowest level since last November, to flirt with last week’s high near 97.50. A band of resistance extends from it to about 97.75. The five- and 20-day moving averages are crossing for the first time since mid-May. Yesterday’s low was not confirmed by the technical indicators, which leaves a bullish divergence in its wake.
As one would expect, the euro’s technical picture is similar to an inversion of the Dollar Index. It’s moving averages are also crossing, for the first time since April 20. A bearish divergence is evident in the technical indicators, which did not confirm the new marginal high yesterday. A break of the late May low near $1.1110 would open the door to a deep pullback, and lend support to out idea that the euro has been carving out a top, helped by speculators who as of last June had the largest net long euro position in six years.
The dollar has approached its 20-day moving average against the yen for the first time since breaking below it on May 17. It is found near JPY110.70 today. It needs to move above there to boost confidence a low is in place. The RSI and Slow Stochastics have turned higher, and the MACDs are about to cross. The US 10-year yield spiked to 2.10% yesterday and is finding better traction now, though at 2.16% is still exceptionally low (compared to the past six months).