Fed Minutes

There weren’t many surprises in the minutes, and they certainly didn’t change anyone’s outlook for Fed policy going forward. 

Regarding the economy, the Fed remained cautiously optimistic. Apparently, though, the lack of a housing rebound is catching some Fed officials’ attention, so housing remains a key area to watch (reports coming out today and tomorrow are important).  But, overall there appears large agreement that the economy was rebounding from a weather-induced slowdown in Q1. 

The other focus of the meeting was on the Fed’s exit strategy from QE.  I think that reflects two things:  First, it’s going to take a big negative shock to the economy to derail tapering of QE, and the outlook for Fed policy (end of QE in October/December, first rate increases mid-2015) is about as set in stone as the Fed outlook can be. 

Second, with the Fed policy outlook relatively “known,” the market’s focus is going to shift more to the specifics of the Fed’s “Exit Strategy” from QE.  And, yesterday’s minutes implied that the Fed doesn’t really know how it’s going to “normalize” policy and its balance sheet (i.e., raise rates while they own so many Treasuries). 

I suppose every plan begins with a conversation, and it seems that the FOMC has started the conversation about normalizing policy – now they just need to come up with a plan.  Assuming the economy stays level through the coming months, Fed exit policy is going to become a more-important topic for the markets. 

Know Where the (Fed) Exits Are

Current (and about to be ex) Fed Vice Chair William Dudley made some comments Tuesday about the Fed exit strategy that were generally viewed as “dovish.”  But, that interpretation is incorrect, and Dudley’s comments may be one reason we saw some bond weakness Tuesday and Wednesday.

The media focused on the fact that Dudley said the “equilibrium” interest rate (a rate that isn’t accommodative or too tight) might be lower going forward than it had been in the past (so say well below 4%).  There are many reasons for that but basically his main thesis is that the economy simply doesn’t have the growth potential it used to (due to demographics and other things). 

That is a “dovish” statement, but it’s not something new. 

Instead, the important part of Dudley’s speech had to do with the Fed exit strategy.  Dudley said he believes the Fed should continue to reinvest principal payments from its QE purchases into other bonds, even after it begins to raise rates (presumably this will soften the blow).  If that opinion reflects the consensus of the FOMC (and Dudley usually does) then that’s a change, as the Fed previously stated it would halt re-investment of QE purchases prior to raising rates.

Now, before your eyes glaze over, this is important because this change in policy may put more upward pressure on rates.

Here’s why: If the Fed stopped re-investing principal payments, that would remove artificial demand from the bond market, and bonds would decline/interest rates would rise faster than if the Fed was reinvesting.  So, not reinvesting principal is a mild form of tightening. 

If the Fed is going to continue to reinvest, though, then any tightening of policy the Fed wants to achieve will have to come solely from interest rate increases, because the rate increases will have to counter the re-investment of principal payments. 

Again, I know this is pretty boring stuff, but understanding Fed policy is key, especially with regard to the expected direction of rates.

Last Week

The economic data last week became a bit of a Rorschach (ink blot) test. Depending what camp you’re in (bull or bear), you could see last week’s data as supporting your case.  But, that aside, the takeaway is that nothing last week changed anyone’s expectations for economic growth domestically or internationally.

For the bears, April industrial production and retail sales both missed estimates.  By themselves those data points weren’t that consequential, as they weren’t big misses.  But, they were disappointing because they imply that the strong gains we saw in the economy in February and March were just part of a “bounce back” effect from the weather-related drop in December/January. And, now that the “bounce back” is over, we’re returning to the recent norm — data that imply 2% GDP growth, not 3% (which is what everyone expects and the stock market needs).  So, the IP and retail sales data were taken to potentially mean we’re not seeing a sustained acceleration in economic activity. 

For the bulls, while the April data were disappointing, the May data released last week were strong, implying the economy is picking up speed again. The Empire State and Philly Fed manufacturing surveys (the first two May economic releases) both beat estimates, with Empire  State coming in at 19.01 vs. (E) 5.0, and Philly registering 15.4 vs. (E) 14.3.  Additionally, jobless claims fell below the 300K mark (297K) for the first time since September (and only the second time for the recovery).  So, the current data imply we are seeing re-acceleration in the economy.

On balance, I’d say last week went in the bears’ favor, as investors and analysts remain very, very skeptical regarding the U.S. economy’s ability to reach “escape velocity” and finally move toward 3%+ GDP growth.

That’s important because if the bears are right (and data last week does not make them right) and the economy does indeed return to the recent “new normal” of 2% GDP growth annually (and not the expected 3%), then the stock market is extended and will correct. 

So, this remains an economy that is short on confidence. Despite current data coming in strong, until we see a more-extended trend, the benefit of the doubt will remain with the bears (but again, that doesn’t mean they are right).

In Europe, the big surprise last week was the weak Q1 GDP report (they can’t blame the weather).  Q1 GDP was just 0.2% quarter-over-quarter vs. (E) 0.4%, and year-over-year was 0.9%. 

That’s a touch weaker than the market expected (the market is expecting a little over 1% this year from the EU, so this stoked some fears about a slower than expected EU economy).  But, the focus remains more on the ECB and what they’ll do next, so this one number didn’t really change the outlook. 

This Week

There’s not a lot of data this week, but Wednesday night and Thursday will be important, especially given the context of the economic confidence problem we seem to have. 

Wednesday/Thursday bring the May flash manufacturing PMIs, with China coming Wednesday night and the EU and U.S. Thursday morning.  Again, the confidence problem isn’t limited to the U.S.  There are ongoing concerns about EU growth given the soft Q1 GDP print, and obviously China remains (and will remain) an ongoing concern.  So, if these flash PMIs can meet expectations or even beat, that will provide a nice confidence boost for the global economy. 

Outside of the flash PMIs, the minutes from the April Fed meeting are released Wednesday, although I don’t think there will be too much revealed in those minutes (perhaps some discussion on inflation and how/when to continue to exit QE, but the policy outlook for the Fed shouldn’t change).  Staying with the Fed, Chair Janet Yellen speaks Wednesday. But it’s at the NYU commencement, so I doubt there will be any revelations about monetary policy.

Finally, housing will remain in focus.  The housing starts number last Friday looked a lot better than it actually was, so the market remains focused on seeing housing rebound from the winter dip like the other parts of the economy.  Existing home sales come Thursday morning, while new home sales come Friday. 

Bottom line: This week won’t definitively alter the outlook for the global economy, but given the continued strength in the bond market (and the potential signal it is sending), strong flash manufacturing PMIs will help give investors a badly needed boost of confidence. 

Overall this was mostly a non-event, although on an otherwise slow news day, the press did try to spin some of her comments as mildly cautious on the economy. (However, the market didn’t really see it that way, evidenced by a stronger stock market and dollar, and weaker bonds and gold.).

In particular, Chair Yellen referred to GDP growth as being “somewhat” higher in ’14 than ’13, and it was the “somewhat” comment that commentators keyed off of, as it was viewed as a slight downgrade.

Additionally, although she said she did not think the stock market was in a bubble, she did cite overvaluation in some small caps.  Finally, she did reference some caution on the housing market, that the recovery might not resume as quickly as anticipated given rising prices.

But, extrapolating those comments out to be cautious on the economy—one week after the FOMC statement was upbeat on the economy—is a stretch. The bottom line with Chair Yellen’s testimony is that the outlook for Fed policy and the economy remains unchanged (continued QE tapering that ends in October/December of this year, first rate hike mid-2015, and 3% annual GDP growth, respectively).