The Fed’s Second Job: Volatility Killer

Last Week: Interest rates fell, and equities rose amid optimism that global growth may be stabilizing. The US 10-year Treasury note declined to 2.58% – a level not seen since early January – from 2.63% a week ago. 1-month LIBOR followed suit, falling throughout the week to 2.4817%. Crude oil rose $3 a barrel to $58.15, as the US Dollar weakened, and Gold rose. Treasury yield volatility rose to 3.76 from 3.69.

The Good: Retail sales rose 0.2% m/o/m, above the expected 0.1% increase. Business inventories rose 0.6% m/o/m, meeting expectations. Job openings rose 1.4% in January from 7.479M to 7.581M. New home sales came in at 607k for January, meeting expectations. Construction spending rose 1.3%, above the expected 0.3% increase. Import and export prices both rose 0.6% m/o/m, beating expected 0.2% rise. CPI (a broad measure of inflation) rose 0.2% m/o/m, meeting expectations.

The Bad: Durable goods orders rose 0.4% m/o/m, decelerating from a previous 1.3% increase. Jobless claims rose 6k w/o/w from 223k to 229k. Industrial production rose 0.1% m/o/m, missing the expected 0.4% increase. Empire State manufacturing survey came in at 3.7, well below the expected 10 reading.

January US retail sales were up but December sales were revised down. US retail sales increased 0.2% month over month in January – driven by an increase in purchases of building materials and discretionary spending by individual consumers. The increase didn’t fully recoup the large decline in retail sales seen in December however, which occurred at the same time equity markets and economic indicators slumped. Taking December’s and January’s retail sales data together, the US consumer is expected to keep spending at a healthy clip as tax cuts, wage growth and positive jobs growth all provide a tailwind to consumer’s confidence in the future. What it means for interest rates: Given that consumers drive 70% of US economic activity, a healthy consumer gives the Fed confidence that economic growth remains healthy and nudges it toward a rate-hiking lean.

A lower reading of US inflation confirmed the Fed’s “wait and see” stance. Consumer prices rose 1.5% in February compared with the same month a year ago, falling from January’s 1.6% pace. Core inflation, which excludes food and energy prices, fell to 2.1% from 2.2% the prior month. Slowing economic growth and falling inflation are giving the Fed plenty of reason to remain on the monetary sidelines over the near term. However, should wages continue their climb and the unemployment rate continue to fall, a stronger, more confident consumer will eventually push the Fed to hike rates.

US-China trade summit date likely to slide into April. In the wake of the failure to reach an agreement at the US-North Korea summit last month in Hanoi – where President Trump walked away without a deal due to unresolved issues – it is believed that China would likely prefer to conclude any trade agreement well in advance of any meeting between Trump and China’s Xi Jinping. With the initial meeting scheduled for late March, and with many unresolved trade issues existing between the countries, the world is concluding that the meeting won’t occur until mid-April at the soonest. As we have said for months now, the US-China trade spat will linger well into 2019, and while the two countries may solve some issues, the more difficult ones, like transfer of intellectual property, may never be solved.

What to Watch This Week: The days ahead will be dominated by the Fed’s March monetary-policy meeting, after which we’ll see the Fed’s revised economic forecasts and get to hear Fed Chair Powell speak at the post-meeting press conference. No one expects the Fed to change its interest rate stance and economic data has been scarce, thus the focus will be on the revised economic forecasts and if they imply a greater likelihood for a rate hike or cut late this year.

It’s widely expected that the themes of “patience” and “data dependence” will dominate the Fed’s communications this week, as recent economic data – which hasn’t been all that upbeat – doesn’t give the Fed any reason to change its wait-and-see tone.

In the shadow of the FOMC meeting, forward-looking data such as the Philadelphia Fed’s survey of business conditions and the index of leading economic indicators will provide clues on how the US economy is responding to international headwinds, last quarter’s financial market swoon and a troubling inventory overbuild. Bottom line: We doubt any scheduled event or data release this week will move interest rates in any meaningful way.

Take-Away: The volatility of Treasury yields has been exceptionally muted of late, recently falling close to a record low not seen since 2017. Fixed-income traders see little reason for a breakout higher or lower anytime soon, as the lingering worries of the progress of US-China trade negotiations, BREXIT and the world’s dominant central banks – like the European Central Bank and the Bank of Canada – dialing back economic growth expectations and being unusually transparent in their plans to do so. The Fed’s likely reiteration of its “patient” stance this week will only encourage the calm to last even longer.

What does that mean for you? Well first and foremost, it means that rate caps will remain on sale for longer. In our daily activity of pricing derivatives of all shapes and sizes in several asset classes (e.g. interest rates, currencies and commodities), we haven’t seen rate cap prices this low in a long time, and we expect it to last a while longer. Thinking of hedging floating rate risk with a rate cap? Now is a good time to do so.

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