Confusion reigns supreme, yield curve continues to steepen

The past few weeks have been somewhat of a rude awakening as investors, lulled into a sense of complacency by persistent low volatility, were shaken from their slumber only to find themselves disoriented and grasping for bearing in the dark.  Diverging rhetoric from global policy makers and conflicting signals from markets are becoming a source of increasing uncertainty, casting shadows of doubt on prevailing economic narratives and challenging the status quo of conventional wisdom.

On Monday, all eyes and ears were on Federal Reserve Governor Lael Brainard as she delivered the final Fed communiqué before a week-long “quiet period” leading up to the September policy meeting.  Brainard’s comments  were eagerly anticipated by traders, many of whom had speculated the unabashedly outspoken dove might suddenly sprout talons and join the growing flock of FOMC members considering a potential rate hike next week. However, instead of setting the stage for a possible pivot in central bank strategy, Brainard used her speech as a soapbox to unequivocally caution against a hasty normalization of accommodative policy. A relief rally in stocks and bonds ensued, although it was short-lived. Indeed, the juxtaposition of Brainard’s remarks amid recently amplified hawkish Fedspeak highlights the proliferation of dissension within the FOMC ranks. For a market desperate for clarity regarding the timing and tempo of potential rate increases, a fragmented Fed only serves to instill confusion and undermine conviction and confidence. It is unsurprising that in a recent Bloomberg News poll 69% of respondents categorized the central bank’s descriptions of policy strategy as “extremely unclear” or “somewhat unclear.”

What’s more, the inherent difficulty of steering investor expectations is not exclusive to the Federal Reserve. Beyond the walls of the Eccles Building, central bankers around the world are faced with the challenge of policy guidance. Bank of Japan Governor Huroki Kuroda was dismissive of negative interest rates in January, only to contradict himself by introducing such policy a week later. ECB President Mario Draghi famously pledged to “do whatever it takes” to tackle stubborn deflationary pressures, yet constantly finds himself disappointing markets by downplaying the possibility of further stimulus. Bank of England Governor Mark Carney talked down the probability of a British recession only a few months after warning of the dire consequences of Brexit. Indeed, contradictions abound. 

The policy-reality divergence, as evidenced by this week’s tepid data flow, indicates a domestic economy that is struggling to find a stable footing in the second half of the year. Stagnation in the factory sector, punctuated by a  0.4% decline in industrial output  for August, continues to hinder productive capital investment. Even more discouraging was the  August retail sales report , which came in considerably weaker than the consensus forecast in the wake of strong sales during spring and early summer. Barring a significant pickup in September, the momentum stall is a dent in the armor of those relying upon consumer spending - fueled by sustained job growth and rising incomes - to shoulder the burden of economic growth.

This lukewarm data would seem to undermine any credible possibility of a rate hike next week.  The latest reading of consumer price inflation,  however, helps bolster the position of policy makers eager to act sooner than later. The annual growth rate of core CPI advanced 2.3% year-over-year, the highest level in eight years. The August figures exceeded both Street expectations and – more notably – the Federal Reserve’s 2% inflation target. While the prospect of rising price pressures is encouraging, it is anomalous in the context of otherwise uninspiring economic data. Given that inflation is a lagging indicator, August’s uptick could prove transitory amid slowing growth momentum. As such, it may be too soon for the hawks to declare victory.

"This asymmetry in risk management in today’s new normal counsels prudence in the removal of policy accommodation. I believe this approach has served us well in recent months, helping to support continued gains in employment and progress on inflation. I look forward to assessing the evolution of the data in the months ahead for signs of further progress toward our goals, bearing in mind these considerations."

- Lael Brainard​, member of the U.S. Federal Reserve's Board of Governors, in Monday's  speech , the last word from a Fed official before the quiet period sets in leading up to the September meeting