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  • Powell's testimony prompts 6-8 bp dovish shift in fed funds futures curve
  • U.S. headline CPI expected to cool slightly 
  • 30-year T-note auction to yield near 2.58% 

Powell's testimony prompts 6-8 bp dovish shift in fed funds futures curve -- The federal funds futures curve on Wednesday turned more dovish by 6-8 bp in response to Fed Chair Powell's testimony and the afternoon release of the dovish June 14-15 FOMC minutes.

Mr. Powell took a "glass half empty" view of the outlook by stressing downside risks and below-target inflation.  Mr. Powell made no attempt to dissuade the markets from their 100% expectation for a -25 bp rate cut at the next FOMC meeting in three weeks on July 30-31.

Fed Chair Powell said that since the June FOMC meeting, "it appears that uncertainties around trade tensions and concerns about the strength of the global economy continue to weigh on the U.S. economic outlook."  He added that weak readings on inflation could be "even more persistent than we currently anticipate."  He said that "manufacturing, trade and investment are weak all around the world."  He said the strong June payroll report of +224,000 was "great news" but was not enough to tilt the balance in a positive direction.

The minutes from the June 18-19 FOMC meeting released later in the day confirmed that most of the other FOMC members were fully on board with Mr. Powell's dovish views.  The minutes said that, "Many participants noted that they viewed the risks to their growth and inflation projections, such as those emanating from greater uncertainty about trade, as shifting notably over recent weeks and that risks were now weighted to the downside."

The FOMC minutes said, "Many judged additional monetary policy accommodation would be warranted in the near term should these recent developments prove to be sustained and continue to weigh on the economic outlook."  The time reference to "near-term" suggested a rate cut at the next meeting on July 30-31.

The market is still discounting the odds at 100% for a rate cut at the July 30-31 FOMC meeting and at a very small 8% for a 50 bp rate cut at that meeting, based on the current Aug federal funds futures contract relative to the current IOER rate of 2.35%.  The market is now expecting an overall -64.5 bp rate cut by the end of 2019 (i.e., 2.6 rate cuts) and a further -29.5 bp of rate cuts in 2020 (i.e., 1.2 rate cuts).

We continue to believe that the FOMC will proceed with the expected -25 bp rate at the July meeting to 2.00-2.25% but will then be much stingier with any further rate cuts later this year, keeping their gunpowder dry in the event that the outlook suddenly deteriorates sharply.

 

U.S. headline CPI expected to cool slightly -- The consensus is for today's June headline CPI to ease to +1.6% y/y from May's +1.8% and for the core CPI to be unchanged from May's +2.0% y/y.

Fed Chair Powell on Wednesday referred to the weak inflation outlook as a justification for the Fed's current bias towards a rate cut.  In the past, Mr. Powell has said that the Fed believed that low inflation was likely due to transitory factors.  However, Mr. Powell on Wednesday said, "There is a risk that weak inflation will be even more persistent than we currently anticipate."

The Fed's preferred inflation measure, the PCE deflator, is in substantially weaker shape than the CPI.  In May, the headline PCE deflator was at +1.5% y/y and the core deflator was at +1.6% y/y, both well below the Fed's +2.0% inflation target.  The core PCE deflator touched a 7-year high of +2.0% on several occasions during 2018 but so far this year has been below +2.0% in every month.

Meanwhile, market expectations for inflation have also been subdued.  The 10-year breakeven inflation expectations rate reached a 5-year high of 2.20% in mid-2018 during the midst of the economic mini-boom sparked by the massive 2018 tax cut.  However, the breakeven rate then fell sharply in late 2018 and fell farther in May to a 2-3/4 year low of 1.61%, generally following crude oil prices.  The breakeven rate has rebounded mildly higher in the past several weeks and is currently at 1.74%, which is still comfortably below the Fed's +2.0% inflation target. 

 

30-year T-note auction to yield near 2.58% -- The Treasury today will conclude this week's $78 billion coupon package by selling $16 billion of 30-year bonds.  Today's auction will be the second and final reopening of the 2-7/8% 30-year bond of May 2049, which the Treasury first sold in May.

The 30-year T-bond yield on Wednesday rose to a 3-week high of 2.597% and closed the day +3.5 bp at 2.576%.  The 30-year yield was pushed higher by supply pressures ahead of today's auction and by a 1-month high in the 10-year breakeven inflation expectations rate sparked by the Wednesday's sharp +4.50% rally in Aug crude oil prices.  Wednesday's mild rise in the 30-year yield bond yield came despite the dovish Powell testimony and FOMC minutes.  The current 30-year yield of 2.576% is up by +12.1 bp from last Friday's 2-3/4 year low of 2.455%

The 12-auction averages for the 30-year are as follows:  2.27 bid cover ratio, $6 million in non-competitive bids taken by mostly retail investors, 5.0 bp tail to the median yield, 36.0 bp tail to the low yield, and 49% taken at the high yield.  The 30-year T-note is of average popularity among foreign investors and central banks.  Indirect bidders, a proxy for foreign buyers, have taken an average of 60.8% of the last twelve 30-year T-bond auctions, which exactly matches the median of 60.8% for all recent Treasury coupon auctions.

 

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