Bond Market Week In Review January 7-11

Summary

• The latest Fed Minutes indicate a clear change in policy.
• Speeches by Fed presidents support this analysis.
• The yield curve continues to narrow; we're seeing modest inversions in small sections of the yield curve.

The latest Fed Meeting Minutes were posted on Wednesday. They indicate a clear change in policy. Here's the first (emphasis added):

After taking into account incoming economic data, information from business contacts, and the tightening of financial conditions, participants generally revised down their individual assessments of the appropriate path for monetary policy and indicated either no material change or only a modest downward revision in their assessment of the economic outlook.

This is a very clear statement, leaving no room for doubt: the pace of rate hikes will slow. This is not the only citation indicating that a slower pace of rate hikes is on the cards (emphasis added):

With regard to the outlook for monetary policy beyond this meeting, participants generally judged that some further gradual increases in the target range for the federal funds rate would most likely be consistent with a sustained economic expansion, strong labor market conditions, and inflation near 2 percent over the medium term. With an increase in the target range at this meeting, the federal funds rate would be at or close to the lower end of the range of estimates of the longer-run neutral interest rate, and participants expressed that recent developments, including the volatility in financial markets and the increased concerns about global growth, made the appropriate extent and timing of future policy firming less clear than earlier. Against this backdrop, many participants expressed the view that, especially in an environment of muted inflation pressures, the Committee could afford to be patient about further policy firming.

Rates are already close to neutral. More importantly, recent events increased the possibility that downside shifts to growth are possible. As a result, the Committee now has the luxury of waiting to see what happens rather than having to act proactively (which has been the underlying rationale for its recent actions).

We've had a few Fed presidents speak over the last seven days. All are now on board with a slowdown in the pace of rate hikes. Cleveland President Mester - who was until recently a strong hawk - has softened her policy prescription (emphasis added):

The U.S. economy is "in a really good spot," said Mester, who was a voting member of the policymaking Federal Open Market Committee in 2018 but is not this year. "If we don't see inflation picking up and we see the labor market staying reasonably strong from where we are now, that may tell us we're not neutral."

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Her analysis is based on inflation: because it hasn't meaningfully increased, she argues (correctly) that rates are above neutral and therefore don't need to be raised much further. Currently, both measures of CPI and overall PCE prices are slightly above 2%; core PCE is just below 2%. Inflation expectations (the difference between a CMT and its corresponding TIP bond) have dropped the last month. These developments indicate price pressures are weak, which means Mester probably doesn't see the need for an increase.

Atlanta Fed President Bostic is also more dovish, but for different reasons (emphasis added):

Atlanta Fed President Raphael Bostic on Monday said the central bank may only raise interest-rates once this year, according to several reports. In a talk in Atlanta, Bostic said he had previously penciled in two moves for this year.

While the economy was healthy, Bostic said "clouds" have developed over the outlook and his business contacts were uncertain about the way forward.

Over the last few months, global data has been somewhat weaker. Perhaps more importantly, business sentiment is growing more cautious, which was apparent in the latest ISM Manufacturing Report's anecdotal comments and Beige Book.

Boston Fed President Rosengren is also in a "wait and see" mode (emphasis added):

My baseline forecast still assumes growth somewhat above potential, and some modest declines in the unemployment rate over this year. Nonetheless, I am sensitive to the heightened risks, and believe that policy is currently appropriately balancing risks. Should these risks materialize and significantly impact the economy, resulting in an economic slowdown - which is not my baseline forecast - policy would need to recalibrate for that less-favorable environment. But at this juncture, with two very different scenarios - economic slowdown implied by financial markets; or growth somewhat above potential GDP growth, consistent with economic forecasts - I believe we can wait for greater clarity before adjusting policy.

This sentiment was mirrored in the Minutes (see above; in fact, the Minutes' quote may have been from Rosengren).

And finally, we have Chicago Fed President Charles Evans, who is also more dovish (emphasis added):

That's eventually. What about the timing? Because inflation is not showing any meaningful sign of heading above 2 percent in a way that would be inconsistent with our symmetric inflation objective, I feel we have good capacity to wait and carefully take stock of the incoming data and other developments. If they warrant meaningful adjustments to my modal outlook or the balance of risks to the economy, then I would change my views of the appropriate path of policy accordingly.

As for the yield curve, it continues to narrow:

The above graph shows the spreads between the 10-, 7-, and 5-Year Treasury bonds and the 3-Month Treasury bill. While each has widened in the last few days, all are in a clear downward trajectory.

We've also seen small inversions in the belly of the curve: