Blaine 2018-05.jpg

by Blaine Dickason
Vice President, Fixed Income Trading and Analysis

While yesterday was Major League Baseball’s Opening Day, this week’s 0-for-7 statistic unceremoniously belongs to the Federal Reserve for failing to achieve its 2 percent inflation target since it was established seven years ago. The Fed’s near-zero interest rate policy and unprecedented monetary stimulus, intended as dry tinder to spark animal spirits, has instead more closely resembled damp newspaper. 

In January of 2012, former Federal Reserve Chair Ben Bernanke established a 2 percent inflation target as measured by personal consumption expenditures (Core PCE) as being most consistent with their price stability mandate. With the Great Financial Crisis still fresh on policymakers’ minds, this target provided a quantitative level to counter deflationary fears. Ironically, as can be seen in the chart below, using the Fed’s own preferred measure of Core PCE, inflation peaked the month of the announcement and has only made one brief visit above 2 percent in the seven years since.

Source: Federal Reserve Bank of St. Louise

Source: Federal Reserve Bank of St. Louise

Last week, current Fed Chair Jerome Powell noted that downward pressure on inflation was “one of the major challenges of our time.” Lower interest rates, partially reflecting both lower inflation AND inflation expectations, leave central bankers much less room to cut rates in order to stimulate the economy during the next downturn.

The U.S. central bank may be good at curtailing inflation (and growth!) with their interest rate hikes, but unfortunately, they get a poor grade for stimulating its creation. With fiscal stimulus being the story behind strong economic growth in 2018, it is still unclear what will lead us in 2019 and beyond. Ultimately, unless the Federal Reserve develops new tools or policies to more successfully achieve their inflation target, we are likely to continue to experience lower absolute interest rates for the foreseeable future.

Fed Ripples

The Federal Reserve may not have cut interest rates at their meeting last week, but their impact on the bond market in the days since may have been just as significant as interest rates across major developed markets trended sharply lower. For example, in just the last week, Germany auctioned their 10-year bonds at negative yields for the first time since 2016! Clearly, slowing global growth coupled with recent central bank dovishness (both the U.S. Federal Reserve and the European Central Bank) have emboldened bond investors to chase yields lower and in some cases invert yield curves as market-based expectations reflect and anticipate actual interest rate cuts.

While falling bond yields are not normally a signal of strong economic growth, there are still positive developments in financial markets that come with lower rates. As exhibited below, since the Fed’s meeting just eight business days ago, the 30-year fixed conventional mortgage rate as tracked by Bankrate.com has dropped another quarter point and is flirting with 4.00 percent after reaching as high as 4.82 percent last November. The U.S. housing sector has historically had a strong multiplier effect on our economy and these lower borrowing costs for both new home purchases and mortgage refinancing should not only improve affordability, but also provide fresh stimulus that may arrest our current growth malaise and help deliver the soft landing so desired by the Federal Reserve.

Source: Bankrate.com via Bloomberg

Source: Bankrate.com via Bloomberg

Week in Review and Our Takeaways

  • The S&P 500 ended the first quarter today with a total return of +13.6 percent, a sharp contrast to the -13.52 percent total return in the prior quarter

  • Fourth quarter 2018 GDP was revised down to 2.2 percent from the prior 2.6 percent this week, which led to a full 2018 calendar year growth of 3.0 percent

  • The Core Personal Consumption Expenditures (PCE) reported this week for January 2019 again disappointed with a reading of 1.8 percent