Powell Charts the Fed's Course

Yesterday Federal Reserve Chair Jerome Powell gave his first of two days of testimony before Congress. Yesterday was in front of the Senate, today will be with the House. Here is what he said, what he meant, and what you should do about it in your investments.   The Fed's Victory Lap Powell and Co. are probably feeling pretty good about themselves. Since he last testified before Congress, things have gotten better for the Fed on every front. Inflation has rebounded to about 2% and unemployment keeps falling. Powell spent the first section of his prepared remarks figuratively beating his chest over how well things are going.   In this section Powell was mainly just stating facts we all know, but it does give us some insight as to where their head is. The Fed came under fire in some circles last year when Core PCE inflation fell to 1.3% yet they were still hiking. At the time they claimed that the deflationary forces were transitory and rate hikes were still appropriate. That turned out to be exactly correct. By hiking slow enough such that any one hike has a very mild effect on the economy, yet fast enough that they aren't falling behind the inflation curve, the Fed appears to have prolonged the Goldilocks expansion.   For now? A lot of people are focused on the Chair adding the phrase "for now" into this sentence: "the FOMC believes that - for now - the best way forward is to keep gradually raising the federal funds rate." Why say it that way? Is this hinting that "for now" might not be that long? I have to admit when I first heard it, I didn't think anything of it. It seems more like a classic Fed Chair move of refusing to commit to anything he doesn't have to commit to. I think he has pretty good visibility that they will want to be hiking in September and December, and then beyond that, who knows? The "for now" qualification within that sentence is probably just a nod to the "who knows?" factor, not really any kind of hint about his future intentions.   I think the right base case is that the Fed just keeps hiking at a 1x per quarter pace until there are real signs of economic weakness or meaningful inflation acceleration. The fact that everything is going so swimmingly has emboldened them to continue on such a path even in the face of mild data deviations. Hence I doubt they change this pattern until there is actually a major data deviation.   Most of the economics questions were on politics not policy I know... shocking right? There wasn't much to glean either way from the senators' questions as Powell stuck to the party line. Trade barriers are bad, tax cuts can be stimulative but need to watch the deficit, etc. He answered these questions with the deftness of the seasoned Washington insider that he is.   The one more substantive question he got was from Senator Pat Toomey of Pennsylvania, who basically asked whether the flattening yield curve suggested the Fed should change their normalization plans.   Powell just about ducked the question. "I think what really matters is what the neutral rate of interest is." By this he means if the Fed's target is still below neutral, there's no reason to think that rate hikes will cause a recession. If the Fed hikes above neutral, then policy is indeed restrictive and could lead to a recession.   But that answer is really just a deflection. Obviously what he's saying is true on its face. However since we don't know what the neutral rate actually is, the shape of the curve is probably the best indicator as how close to the "real" neutral rate we are. For instance, Powell in his response guided Toomey to the Fed's "long-term" section in the dot plot as an estimate of the neutral rate. That would suggest somewhere near 3% is neutral. I guess we could assume that the Fed thinks they can hike up to 3% without inverting the curve. However unless the market assumes that the Fed will literally just hold at 3% indefinitely, that won't be true. Either the market will expect more near-term hikes, in which case the 2-year will be higher than 3% OR the market will assume cuts are coming and the 10-year will be lower than 3%.   Hence unless you somehow think the Fed is going to a) pause after 2-3 more hikes OR b) will perfectly thread the monetary policy needle, expect the yield curve to invert later this year.   So what are the trades? · Odds of a December rate hike should be more like 80%, not 60%. Powell's testimony sure indicates he's plowing forward with hikes. As the market comes around to that view, short-term rates will rise and the yield curve will keep flattening. You can either buy FLAT or go long TLT and short IEI. Alternatively you can go long DFVS, which is a bear 5-year ETN. · The Fed won't thread the needle. The Fed will hike too far at some point. They always do. Bet on the curve inverting this year. Trades above make all the more sense given this.      
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