U.S. Rates: The Fed at Work

Mid Week Bond Update

U.S. Rates: The Fed at Work

The Federal Open Market Committee (FOMC) has more on its mind than the date and direction of its next move on rates.


U.S. Rates: The Fed at work

Prices in the Fed Funds futures market reflect a 96% probability that the FOMC will leave its target interest rates unchanged at the conclusion of its meeting on May 1. But further out, the picture gets more complicated.

The futures market for overnight interest rates two years out is widely accepted as a barometer of sentiment about the Fed Funds target rate. Since the Fed’s last rate hike in December 2018, the two-year future has changed its tune at least twice. As recently as March 27, the future was priced as if the next move by the Fed would be a rate cut. Since that date, the future has moderated on this point but remains notably below the 2.50% upper bound of the Fed’s rate regime. In an environment where economic growth continues to exceed expectations, it's clearly possible that the 2-year future could head upward at some point.

Some Fed observers, including Western Asset, believe that the Fed is now concentrating on matters of inflation rather than rates, examining the economic models it uses for embedded assumptions that might be at odds with how the economy is currently structured.  Whether that means a more dovish Fed until inflation actually surfaces, or some quantitative objective other than inflation, remains to be seen.
 

U.S. Overnight Interest Rates, 2-Year Forward, vs. Fed Funds Target Rates

Chart: U.S. Overnight Interest Rates vs. Fed Funds Target Rates

Chart adapted from Western Asset. Sources: Federal Reserve, Bloomberg, as of 4/30/2019.  Past performance is no guarantee of future results. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

 

On the rise: U.S. Consumer spending  

The strong U.S. consumer figures for March countered recent worries surrounding the brief inversion of part of the U.S. yield curve last month.

Personal consumption spending rose 0.9% in March vs. February, the largest one-month rise since the end of the 2008-09 recession. That spending was 0.7% for the month over and above the month's rise in prices. Spending appears to have come out of foregone saving; personal income rose 0.1%. The data are consistent with rising consumer confidence indicated in other unrelated surveys.

Inflation, however, remained stubbornly low.  The Fed's favorite measure, PCE inflation, rose 0.2% for March, bringing the trailing 12-month figure to 1.5%. Core inflation, not including food and fuel, didn't rise at all in March and was up only 1.6% for the past 12 months.  Both core and headline PCE inflation remained notably below the Fed's 2% target range, giving the FOMC yet more data to work with when considering how to boost prices when growth isn't yet doing its job.
 

On the slide: Estimated U.S. government borrowing

The quarterly Treasury Department estimates of government borrowing for the following six months contained a reduction, rather than an increase, in the total for the quarter ahead, with potentially unexpected effects on the supply of Treasuries – and therefore, on future prices and yields.

The department expects to issue $30 billion in privately-held marketable debt between April and June.  That amount is some $53 billion lower than the estimate it made in January and presumes that the department will finish the period with a cash balance of $270 billion as of June 30.

The reduction from the previous estimate is due to Fed policy rather than fiscal restraint.  As the Fed slows down its "quantitative tightening" policy of redeeming $30 billion per month of Treasuries it has on hand, the Treasury Department will need correspondingly less cash to pay for those redemptions – and therefore will need to borrow less in the open market in the coming months.

This is not to say that overall government spending will be reduced – far from it.  Rather, some of the money needed to fund the government's operations will be coming from a different source.

 


All data Source: Bloomberg as of April 30, 2019 unless otherwise specified.


Definitions:

The federal funds rate (fed funds rate, fed funds target rate or intended federal funds rate) is a target interest rate that is set by the FOMC for implementing U.S. monetary policies. It is the interest rate that banks with excess reserves at a U.S. Federal Reserve district bank charge other banks that need overnight loans.

The Federal Open Market Committee (FOMC) is a policy-making body of the Federal Reserve System (Fed), which is responsible for the formulation of a policy designed to promote economic growth, full employment, stable prices, and a sustainable pattern of international trade and payments.

A yield curve shows the relationship between yields and maturity dates for a similar class of bonds.

Inverted yield curve refers to a market condition when yields for longer-maturity bonds have yields which are lower than shorter-maturity issues.

The Personal Consumption Expenditures (PCE) Price Index is a measure of price changes in consumer goods and services; the measure includes data pertaining to durables, non-durables and services. This index takes consumers' changing consumption due to prices into account, whereas the Consumer Price Index uses a fixed basket of goods with weightings that do not change over time. Core PCE excludes food & energy prices.

Quantitative tightening refers to a monetary policy implemented by a central bank in which it reduces the excess reserves of the banking system through the direct sale of debt securities from its own inventory.

 

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