War, Inflation and the Neutral Interest Rate
The likelihood of oil production being targeted as part of the escalating conflict in the Middle East has increased. This was discussed in a webinar by Academy’s General (ret.) Robeson, Rachel Washburn and Peter Tchir. The webinar focused on the uncertainties managers face when dealing with the conflict and highlighted the potential impact of disruptions in oil supply or production on the global economy.
From a military standpoint, Israel has had a series of successes. The attacks using pagers and walkie talkies resulted in injuries and deaths, forced more in-person meetings which were then attacked, and had a significant psychological impact. On the other hand, Iran's ballistic missile attack did not seem to accomplish much. Some missiles hit military targets, but most were intercepted or landed in areas causing minimal damage. This combination of factors suggests that escalation is likely, despite pressure from many countries to de-escalate.
Introducing Inflation Back into the Fed’s Calculations
Friday’s strong job report means that the Fed can no longer focus solely on jobs data. The report included upward revisions, which were expected, and the birth/death model came in at -100k jobs, which is encouraging. With the employment data so much stronger, the Fed is likely to be more cautious in terms of their next steps.
While there is no particular concern about inflation, there are some factors to watch for. These include the risk of higher energy prices due to any major disruption in the Middle East, rising commodity prices across virtually every commodity, and the potential impact of Chinese stimulus on domestic consumption.
The Neutral Interest Rate
The "neutral rate" should be a level of rates that allows the economy to function "normally". However, it is difficult to measure what this normal rate is, so estimates are used. The terminal rate in the dot plot should reflect what the Fed thinks about the neutral rate. At the last meeting, the terminal rate dots were a median of 2.875% but with a weighted average of 2.99%. At the meeting back in March, the median was 2.56% and the average was 2.81%.
There are two reasons why this shift in neutral rates/terminal rate is occurring. Firstly, as the Fed pivots to a new cycle, they can think more about the terminal rate. Secondly, the economy is not acting like the Fed has been as restrictive as a 2.875% neutral rate would imply. The Atlanta GDPNow GDP forecast has averaged 2.9% during this 2 year period, which is what actual GDP has averaged.
Bottom Line
The two-year yield at 3.92% is probably getting close to reality, but a more realistic figure is closer to 4.1%. With 2s vs 10s back to positive and a target of 25 bps, it is expected that 10s will push towards 4.25%.
The reopening of China’s markets this week is expected to impact U.S. markets, particularly if the Chinese market does not hold on to the big gains already priced in. The benefits of stimulus are expected to accrue disproportionately to Chinese companies selling products domestically and commodity producers.
The market responded surprisingly well to the 10-year nearing 4% on Friday. Stocks threatened to fade several times, but decided to ignore the move in yields and to downplay the risk of escalation in the Middle East. This week will be interesting, but the risk is skewed to bigger downside moves, as many of the issues discussed here get coverage and traction.
The upcoming election is also a factor to consider. The base case is "gridlock" and an "uncontested" election. However, the "shock" or "risk to the market" would be some side "sweeping" and being able to enact much more aggressive policy agendas, or real fears about the aftermath of the election growing.
What are your thoughts on these issues? Do you agree with the analysis? Share your thoughts and this article with your friends. Don't forget to sign up for the Daily Briefing, which is every day at 6 pm.
War, Inflation and the Neutral Interest Rate
The likelihood of oil production being targeted as part of the escalating conflict in the Middle East has increased. This was discussed in a webinar by Academy’s General (ret.) Robeson, Rachel Washburn and Peter Tchir. The webinar focused on the uncertainties managers face when dealing with the conflict and highlighted the potential impact of disruptions in oil supply or production on the global economy.
From a military standpoint, Israel has had a series of successes. The attacks using pagers and walkie talkies resulted in injuries and deaths, forced more in-person meetings which were then attacked, and had a significant psychological impact. On the other hand, Iran's ballistic missile attack did not seem to accomplish much. Some missiles hit military targets, but most were intercepted or landed in areas causing minimal damage. This combination of factors suggests that escalation is likely, despite pressure from many countries to de-escalate.
Introducing Inflation Back into the Fed’s Calculations
Friday’s strong job report means that the Fed can no longer focus solely on jobs data. The report included upward revisions, which were expected, and the birth/death model came in at -100k jobs, which is encouraging. With the employment data so much stronger, the Fed is likely to be more cautious in terms of their next steps.
While there is no particular concern about inflation, there are some factors to watch for. These include the risk of higher energy prices due to any major disruption in the Middle East, rising commodity prices across virtually every commodity, and the potential impact of Chinese stimulus on domestic consumption.
The Neutral Interest Rate
The "neutral rate" should be a level of rates that allows the economy to function "normally". However, it is difficult to measure what this normal rate is, so estimates are used. The terminal rate in the dot plot should reflect what the Fed thinks about the neutral rate. At the last meeting, the terminal rate dots were a median of 2.875% but with a weighted average of 2.99%. At the meeting back in March, the median was 2.56% and the average was 2.81%.
There are two reasons why this shift in neutral rates/terminal rate is occurring. Firstly, as the Fed pivots to a new cycle, they can think more about the terminal rate. Secondly, the economy is not acting like the Fed has been as restrictive as a 2.875% neutral rate would imply. The Atlanta GDPNow GDP forecast has averaged 2.9% during this 2 year period, which is what actual GDP has averaged.
Bottom Line
The two-year yield at 3.92% is probably getting close to reality, but a more realistic figure is closer to 4.1%. With 2s vs 10s back to positive and a target of 25 bps, it is expected that 10s will push towards 4.25%.
The reopening of China’s markets this week is expected to impact U.S. markets, particularly if the Chinese market does not hold on to the big gains already priced in. The benefits of stimulus are expected to accrue disproportionately to Chinese companies selling products domestically and commodity producers.
The market responded surprisingly well to the 10-year nearing 4% on Friday. Stocks threatened to fade several times, but decided to ignore the move in yields and to downplay the risk of escalation in the Middle East. This week will be interesting, but the risk is skewed to bigger downside moves, as many of the issues discussed here get coverage and traction.
The upcoming election is also a factor to consider. The base case is "gridlock" and an "uncontested" election. However, the "shock" or "risk to the market" would be some side "sweeping" and being able to enact much more aggressive policy agendas, or real fears about the aftermath of the election growing.
What are your thoughts on these issues? Do you agree with the analysis? Share your thoughts and this article with your friends. Don't forget to sign up for the Daily Briefing, which is every day at 6 pm.
