What Did We Learn Last Week?

FOMC minutes and the employment report last week provided more reasons to expect another 100 basis point increase in the fed funds rate over the next 12 months.  The minutes noted that the Fed Staff expects GDP growth to be “above trend” for the foreseeable future and the unemployment rate to be below the long-term sustainable rate.  That implies that a degree of monetary restraint is appropriate.  Monetary stimulus is no longer the best policy path.  Fiscal stimulus now in place reinforces the need for monetary restraint.  Several Committee members made that point at the FOMC meeting.

Many members also noted that if economic fundamentals mandated continued gradual increases in the funds rate, that rate would be above what they estimate to be the long run neutral rate sometime in 2019.  That neutral rate is generally regarded to be in the 2 3/4% to 3% range.  Thus, most members expect the actual rate to be 3% or higher by the second half of next year.  That is why the Committee dropped the sentences that said that monetary policy would remain accommodative.  It is accommodative now but will likely become restrictive next year, according to the current outlook.

Finally, the Committee increased the amount of balance sheet reduction to $40 billion per month starting July 1.  That will increase again to $50 billion per month in October.  This, at a time when Treasury auction sizes are being increased in order to fund a deficit that is headed for $1 trillion.

The June employment report was entirely consistent with the Committee’s view that the labor market is very strong.  There are now reports of labor shortages throughout the land.  Some FOMC members cited labor shortages as a potential constraint to GDP growth.  A healthy increase in the labor force pushed the unemployment rate to 4% in June, but that is regarded as another indication of a strong labor market.  It is widely acknowledged that the average hourly earnings data are understating the rise in wages now underway.  The FOMC minutes again cited reports from business contacts that cost are rising much faster now that only a few months ago.  That was also the message from the latest ISM reports.

These are the classic ingredients for a bear markets for bonds.  Perhaps because most market participants have not experienced a prolonged rise in rates and bond yields, they expect this episode of rising yields to be over soon (or even over already).  History does not support that optimistic outlook.  To be sure, this is not like the brutal days of the 1970s and 80s, but it is probably a sufficiently bearish outlook that the negative returns seen in the first half for long-duration sectors are likely to persist during the remainder of 2018.

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