US Bond Market Week In Review: The Fed Returns To A Rate Hike Stance

To better understand this week’s Fed announcement, it’s important to compare the economic backdrop between the June 14-15 and July 26-27 meeting. While first quarter GDP growth was ultimately revised higher, the final 1Q report was still a weak 1.4%. Industrial production was still contracting on account of oil sector weakness and to a lesser extent, the strong dollar. May’s weak employment report, showing a paltry 11,000 net gain in establishment jobs, sent shockwaves through the financial markets and the Fed; the report lowered the 12, 6 and 3 month average job growth figures to 204,000, 172,000 and 147,000, respectively. The combination of these factors provided the Fed with enough justification for taking a wait and see attitude regarding rate hikes in June. 

A great deal has changed since in the ensuing 6 weeks. Industrial production has increased in 2 of the last 3 months and the latest employment report showed very strong job gains. The leading and coincident indicators printed their best and second best results in 7 months. Perhaps most importantly, the markets have so far survived Brexit; the equity markets sold off in response to the vote, but have since rebounded, making new highs. The primary negative development is the continued shrinking of the yield spread. But just as May’s weak employment report was insufficient to force the Fed to reverse course, so too are declining bond yields insufficient to prevent a more aggressive stance.

In its latest statement, the Fed argued the economy was increasing moderately, with rising employment and strong household gains. However, business investment and inflation expectations remained weak. These observations have been remarkably consistent over the last 6-9 months.      

The Fed again stated they would take a gradual approach to raising interest rates:

The Committee expects that economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run. However, the actual path of the federal funds rate will depend on the economic outlook as informed by incoming data.