WHAT WILL THE FEBRUARY 1 FOMC MINUTES SUGGEST?

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By: Kent Engelke | Capitol Securities

The Minutes from the February 1 FOMC meeting are released today. Will the monetary timetable be changed yet again? Currently the market is suggesting a 38% chance of an interest rate increase in March. Are these odds understated?

Historically, the Fed’s target for short term interest rates is nominally lower than the trend growth in nominal GDP (real GDP plus inflation). Real GDP is about 3.5%, thus suggesting the overnight rate is considerably lower than historical norms.

Recently, the “animal spirits” are stirring because of the potential of less burdensome financial regulations, tax reform and infrastructure spending.

The yield curve between the overnight rate and the 10-year Treasury is around 180 basis points versus the historical average of 106 bps since the 1950s.

The yield curve between the 10 and 30 year Treasury has been holding consistent, believing the Fed will keep long term inflation and inflationary expectations “well contained.”

Is the market correct, defined as benign inflationary pressures even as rates are very accommodative based upon historical norms? What happens to assumptions if monetary velocity accelerates, which it appears that such an acceleration is now occurring as evidenced by nascent increase in M2?

I cannot underestimate the potential risk at hand if the Fed remains too accommodative too long. Excess bank reserves are around $2 trillion versus the historical norm of $1 billion thus suggesting considerable liquidity for inflationary growth.

The national debt is about $20 trillion, yet the debt service requirements — the amount of money needed to service principle and interest — are around 1996 levels when the national debt was 25% of today’s size. If interest rates rose to “historical norms/relationships,” debt service would increase to around $1 trillion versus today’s level of $325 billion or about 30% of the budget.

Wow! How will this impact government spending and interest rates?

The only constants in life are change and reversion to the mean. Confidences levels — same as animal spirits — have increased by amounts not experienced since 1980.

One of the stated goals of the FOMC, via very accommodative monetary policy and QE, is to force all further out on the risk curve, a policy that may have created tomorrow’s crisis.

Will tomorrow’s headlines be of greater than expected growth that has “unanchored” inflationary expectations because of the loss of confidence in the Fed’s ability to provide price stability?

How will this impact stock valuations and bond prices?

It is against this backdrop I would prefer the Fed to err on the side of caution, defined as increasing rates now in an attempt to prevent tomorrow’s future crisis.

As indicated, the odds are only 38%, perhaps the result of seven years of missed Fed policy and horrific fiscal policy and regulations that killed the “animal spirits,” animal spirits that are now awakening.

Commenting upon yesterday’s market action, equities ended higher on global economic optimism and further gains in oil. Treasuries were essentially unchanged.

Last night, the foreign markets were up. London was up 0.12%, Paris up 0.11% and Frankfurt up 0.18%. China was up 0.24%, Japan down 0.01% and Hang Sang up 0.99%.

The Dow should open nominally lower as all are questioning the sustainability of the advance, an advance that was partially the result of the collapse of the cross correlated trades, perhaps the result of the Trump election which may have completely changed the rules. The 10-year is up 3/32 to yield 2.42%.

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