The Fed Is in Limbo
In yesterday’s analysis, I compared Janet Yellen to an athlete running the high-hurdles at a track meet. Her finish line is a rate hike on December 13.
The hurdles are inflation data, the Trump tax cut, and a government shutdown on December 8. She has to clear all three hurdles to make it to the finish line.
These hurdles are all conveniently time-stamped. The inflation data came out this morning, the tax bill vote is scheduled for Friday, and the government shutdown is scheduled for next Friday, December 8.
As New York Mayor Ed Koch used to ask, “How am I doin’?”
Well, the inflation data this morning was decisively… indecisive.
The particular metric in focus was the personal consumption expenditure core deflator on a year-over-year basis released monthly by the Commerce Department with a one-month lag. Call it PCE Core year-over-year for short.
Sounds technical, but it’s important because that’s the number the Fed watches. There are plenty of other inflation readings out there (CPI, PPI, core, non-core, trimmed mean, etc), but PCE Core year-over-year is the one the Fed uses to benchmark their performance in terms of their inflation goal.
The Fed’s target for PCE Core is 2%. The October reading released this morning was 1.4%. For weeks I’ve been saying that a 1.3% reading would put the rate hike on hold, and a 1.6% reading would make the rate hike a done deal. So, the actual reading of 1.4% was in the mushy middle of that easy-to-forecast range.
What’s interesting is that the prior month was also 1.4%, so the new number is unchanged from September. That’s not what the Fed wants to see. They want to see progress toward their 2% goal.
On the other hand, the 1.4% from September was a revised number. It was earlier reported at 1.3% (the same number as August).
You can read this two ways. If you see the August 1.3% as a low, then you can say the 1.4% readings for September and October were progress toward the Fed’s 2% target. It’s a thin reed, but Yellen could use this to justify her view that the year-long weakness in PCE Core is “transitory.”
On the other hand, these 0.1% moves month-to-month are really statistical noise and may even be due to rounding. The bigger picture is that PCE Core is weak and nowhere near the Fed’s target. Another rate hike in December could be a huge blunder if it slows the economy further and leads to more weakness in PCE Core.
On balance, the PCE Core number is probably just enough (barely) to justify a rate hike. I’ve raised my probability of a December rate hike from 30% to 55%. That’s what good Bayesians do; they update forecasts continually based on new data.
Of course, the market has been pricing in at a 100% probability for a few weeks. That’s fine, markets have been wildly wrong in the past. I’d rather stick with a good model and update continually than swing from one extreme to the other based on crowd behavior. My Bayesian statistical models (along with other scientific tools) have served me well for a long time and I’m sticking with them.
As John Maynard Keynes said, “When the facts change, I change my mind. What do you do, sir?” (Actually Keynes never said that, but it’s a wonderful quote attributed to him. Keynes would certainly agree).
What about the remaining two hurdles for our track-star Janet Yellen?
The tax bill vote is scheduled for Friday. If it passes the Senate, it will almost certainly become law in the next few weeks after the House and Senate versions are reconciled.
The stock market has already priced in a tax cut. Markets won’t go up much more if the bill passes because they already expect it to pass. But if the bill fails markets could plunge on the bad news.
That’s important. If it does not pass, the disappointment factor will be huge and could send the stock market tumbling. Something like that happened in 2008 when the TARP legislation failed. The Dow fell over 700 points in one day. (Congress got the message and passed TARP a few days later). The response would be much larger today, perhaps 1,000 Dow points or more, because the market is starting from a much higher level.
The fact is no one knows what will happen in the Senate; at least eight Senators are waiting for a “Manager’s Amendment” (basically a re-write of the entire bill) to make up their minds.
Call it 50/50; a coin toss. “Heads” the Senate passes the tax bill, “tails” they don’t. But if the tax cut fails and the market tumbles, the Fed will not raise rates.
Finally there’s the government shutdown if Republicans and Democrats cannot agree on spending. These are mostly for show; most of the government remains open and the shutdowns are usually resolved within a week or so.
That means finding some compromise on a long list of hot button issues including funding for Trump’s wall with Mexico, deportation of illegal immigrants brought to the U.S. as children (the “Dreamer Act” also referred to as “DACA”), funding for Planned Parenthood, funding for Obamacare (called “SCHIP”), and more.
Still, it’s difficult to imagine the Fed hiking rates on December 13 if the government shuts down on December 8 and remains shut on the date of the FOMC meeting.
There’s not much middle ground between Democrats and Republicans on spending policy issues like immigration, Trump’s Wall, Obamacare bailouts, and a host of other hot button issues.
This looks like another 50/50 call. “Heads” the government stays open, “tails” the government shuts down.
The problem with two coin tosses is that the odds of getting “tails” at least once are 75%.
So, Yellen still has a long way to go before she crosses the finish line.
My trading recommendation is unchanged. The euro, yen, gold and Treasury notes are all fully priced for rate hike. If it happens, those instruments won’t change much because the event is priced. If there’s no rate hike, euros, gold, yen and Treasury notes will all soar.
So, there’s an asymmetry in the probable outcomes. If you go long euros, gold, yen and Treasury notes, you won’t lose much if the Fed hikes (assuming no geopolitical shocks), but you could win big if they don’t.
That’s the kind of coin toss I like. Heads I win, tails I don’t lose.