It's official; everyone is now musing about the risk of a Fed "policy mistake" in light of the steadily flattening yield curve in the U.S. I have mused incessantly about this topic in recent weeks, so I will spare you the gory details of my view. It seems clear, though, that if markets were willing to offer the FOMC a rate hike in June for free, they are not going to roll over in September, let alone play along with a potentially fourth hike in December. In other words; the Fed is now on the spot. A swoon in risk assets over the summer—it has been known to happen—coupled with a further decline in long term bond yields would set up an interesting end of the year for the Federales. I am sympathetic to idea of one last deep dive in long-term bond yields to cement the fate of the late-comers to this rally. After all, we can't really talk about a policy mistake at the Fed before we are staring down the barrel of an inversion.
We have had the first proper summer days in the north east of England this weekend, and they've been delivered just in time for the Hoppings. For those uninitiated in the folklore of Newcastle living, it does not get much better than that. It is tempting to extrapolate this state of affairs to the coming months, and hope for a warm summer lull. But experience suggests that would be complacent. Rain is forecast for next week. We should enjoy it while it lasts.
In markets, last week offered up another pinch of curve flattening across the pond. The Fed raised rates, as expected, and also signalled one more hike this year. The hawkish bias surprised some punters which had been looking for the Fed to climb down in light of recent underwhelming inflation prints. As far as I can see, though, the Fed didn't really veer off course. Central banks are like super tankers; they move slowly and persistently. The FOMC reiterated that it is in a three-hikes-a-year mode and that it continues to expect the labour market to tighten. If this is a traditional cycle, the Fed will stay the course until something breaks somewhere.
I vividly remember my first desktop computer. It was a mighty machine powered by an AMD Athlon 800mhz processor with 64mb ram. As a true geek, I upgraded it several times and with respect to the graphics cards, there were only two choices at the turn of the century. You either went with AMD's Radeon chips or NVIDIA's GeForce range. My choice settled on a Radeon with 64mb; AMD was the underdog at the time, but their Radeon cards were top quality. It offered crisp pictures, and smooth gameplay, to support my career as online gamer in the Unreal Tournament clan The Viper's Nest. The world has moved on since then. I am no longer as adept with an Instagib rifle as I used to be, and NVIDIA no longer only relies on selling graphic chips. Today the firm is centre stage in the debate on whether U.S. tech stocks—and the infamous FANGs—are in a bubble.
Let's assume that you think the Fed will raise rates two more times this year, and for the sake of argument three times in 2018. It stands to reason that your forecast for two-year yields at the end of next year has to be about 2.5%-to-3.0%. The argument for this sequence of events seems fairly straightforward. The U.S. economy is growing—albeit not spectacularly—, unemployment is sub-5%, and the FOMC is anxious to put the era of super-loose monetary policy behind it. The key question, though, is what your corresponding forecasts for 5-year and 10-year yields are, because we're closer to a do-or-die moment for bonds and the Fed's "hiking cycle."
I think we're looking at a four-scenario outlook.