On Tuesday minutes from the Federal Reserve’s Discount Rate Committee meeting on July 25 were released. A total of 8 regional banks out of 12 asked for an increase in the rate, from 1% to 1.25%, up from 6 of 12 at the previous meeting. The board ultimately decided to keep the rate unchanged at 1%. However, this piece of news confirms that the Fed is getting ever closer to pulling the trigger on another hike. Although economic data pertaining to growth has been somewhat mixed, there is currently reason to believe that the Fed’s tired repetition of expecting to reach its 2% inflation target may finally come true by the middle of the year.
There are several reasons for this. First, consider the price of crude oil. The October contract (CLV6) settled at 48.10 yesterday, and one year ago it was also in the upper 40’s. However, by January and February of this year it had traded below $27/bbl. The average price over the months of Jan and Feb was right around $32. Therefore if oil stays around its current level, by year end 2017 oil will be up 50%, (that is, from 32 to 48). The same analysis holds true when using the Bloomberg Commodity Index. In Jan and Feb it was around 75, and now it’s 86 (up approx. 15%), having been as high as 90 in June. That’s in spite of the drubbing that has occurred in the grain over the past two months.
Second, average hourly earnings have been slowly accelerating on a year over year basis. In the last employment report, the yoy rate was 2.6%. Throughout 2013 and 2014 this growth rate bounced around 2.0 to 2.2%. Also note, again referring to the Discount Rate minutes above, that “…many directors reported increasing tightness in the labor market for certain skilled positions.”
Third, and this is a rather powerful macro thought, global trade has taken a step backwards. The movement towards globalization and the free flow of goods and services has been a major factor in keeping prices under pressure. However, trade has stalled, and with terrorism concerns and trade barriers being considered, pricing may be less restrained by global competition.
On a final anecdotal note, many have seen increases in health insurance rates (note that health care spending is an astonishing 17% of GDP) and in property taxes, which filters into shelter costs for both renters and owners.
Against these changes, I would point out that the US yield curve is flat as a pancake. For example, the spread between the 2 year and 10 year treasury yields is just 80 bps. One year ago this spread was more like 140 bps. It may take a couple of months for these realities to sink into the market’s consciousness, and many will be led astray by continued mediocre growth data. However, the Fed can be taken at its word (finally) in terms of gradual rate increases, and the US curve is likely to steepen going into the beginning of 2017.
Alex Manzara
