Discussing the market's ongoing reaction to the schizophrenic split between the hawkish Fed and a market which now sees a 50% lower terminal Fed Funds rate than the FOMC, yesterday Jeff Gundlach said that the flattening yield curve could become a concern for US economic growth when two and three-year notes yield about the same.
"Lower CPI in the next couple of months will be a cold bucket of water for the Fed tightening dreams," Gundlach said. "Commodities are super weak, with the dollar down year-to-date, no less."
In not so many words, an error is forming: either "policy error" by the Fed, or one by the market, which will be forced to reconcile its dovish stance, potentially in violent fashion, with the Fed's relentless "data independence."
It was this issue that was the topic of a note by Bloomberg's macro commentator Garfield Reynolds, who noted in his overnight Macro View note, that in addition to the Gundlach "quandary", if recent commentary by BlackRock and Pimco is right, then "another Fed shock looms."
His full note below:
Another Fed Shock Looms If BlackRock, Pimco Right: Macro View
Once bitten, twice eager sounds like a contradiction but it can often seem like standard operating procedure in global markets - just look at the money piling into bets that the Federal Reserve is going nowhere soon with monetary tightening. It’s as if the February shock - when a deluge of Fedspeak made traders realize their bets against a March hike were wrong - never happened.
Even after Fed Chair Janet Yellen made it clear she anticipates further rate increases, the “policy error” narrative is going full bore. Eurodollar options and fed funds futures signal no more moves for at least three months and no more than one more this year.
Inflation is stubbornly low. Continuing sluggishness in U.S. data (surprise indexes are at about full disappointment settings) could stay the Fed’s hand, especially if employment joins the pity party.
But BlackRock and Pimco, who between them manage more than $6.5 trillion, indicated separately this week that weaker data may not necessarily be the end-all and be-all for the rate outlook.
Fed officials have noted their mandate goes beyond just looking at the current pace of inflation. That means the “excessive obsession some market watchers have with the Fed hewing to its 2% inflation target is shortsighted,” according to Rick Rieder, BlackRock’s global chief investment officer of fixed-income.
Pimco’s Joachim Fels says Yellen may be willing to accept lower inflation as she continues with the Fed’s policy path because for one thing it would then give greater scope for policy action down the road, and it could enhance financial stability amid concerns of rates being too low. And he cites interesting theories about higher nominal rates leading to higher longer-term inflation.
The complacency in the bond market (10-year yields are heading for their narrowest monthly range since 2004!) and elsewhere seems especially brave considering how recently the market completely failed to read the Fed.
Of course, there is another explanation, one offered by BofA earlier this week which suggested that the decoupling between the Fed's tightening intentions and the underlying economy has little to do with the data, and everything to do with the market bursting the stock market bubble. As BofA's chief strategist David Woo said, "Can it be the case that its hawkishness was prompted by something other than its reading of the economy? For example, is it possible that the Fed has become concerned about the recent surge in the equity market, especially tech stocks that has been feeding off low interest rates and low volatility?" If so, a "market shock" is indeed inevitable, the question is when.
Then again, the market may be doubly-right: if Yellen does indeed "shock" the market, sending yields surging and risk assets tumbling, then a recession is virtually assured. As such, bond bulls are predicting not only its own near-term demise, but their long-term vindication after the shake out that will follow the "post shock" period.