Federal Reserve Governor Christopher Waller started the idea in late November that the Fed would be cutting rates soon but he took that away yesterday, likely causing a near-term inflection point towards higher short-term Treasury yields.

It was a major moment for the bond and stock markets in late November (11/28/2023) when Governor Waller proposed the idea that the Fed may cut rates soon just because inflation has fallen; without economic weakness. In response to a question from Nick Timiraos of the Wall Street Journal, he said,

“Now, if you think about in central banking, we talk about a Taylor rule or various types of Taylor rules to kind of give us a rule of thumb about how we think we should set policy and every one of those things would say “if inflation is coming down”, you don’t need to keep, you know once you get inflation down low enough, you don’t necessarily have to keep rates up at those levels. So, there is certainly good economic arguments from any kind of standard Taylor rule that would tell you that if we see disinflation continuing for several more months. I don’t know how long that might be, 3-months, 4-months, 5-months, that we feel confident that inflation is really down and on its way, that you could then start lowering the policy rate just because inflation is lower. It has nothing to do with trying to save the economy or recession. It is just consistent with every policy rule that I know from my academic life and as a policy maker. If inflation goes down, you would lower the policy rate.”

And from that one answer, the stock and bond markets began to get the idea that the Fed would cut rates soon (implied to be within 5 months or the end of April) just from inflation coming down. His words were a big factor in pricing expectations for the first rate cut to be in March 2024 and proportionately, bringing 2-year Treasury yields lower. Risk-markets took it even further to mean that the Fed could pre-empt a recession, spurring the latest round of hopeful “soft-landing” expectations. (As an aside and topic for another time, Fed policy is best thought of as a mitigation to what comes from the economy; not a major cause of the economy as is popularly thought.)

While Governor Waller is correct that lower inflation brings down Taylor rule prescriptions for where Fed Funds should be, the Baseline Taylor Rule Model still suggests Fed Funds should be higher than it is now (7%.) Even if inflation fell all the way back to 2% and the unemployment rate stayed where it is (i.e., no economic weakness), the Baseline Taylor Rule Model would drop to just 5.3% or where the Fed Funds rate is now; still not suggesting a Fed cut. This Model is only going to suggest lower rates when the unemployment rate rises. While the Fed regularly deviates from it, because the high inflation of 2022 is so recent and, I don’t think they are going to materially undercut it without an offsetting factor like an economic shock.

And so, Waller’s guidance of the Fed cutting within five months without economic weakness, and a major precept to how markets traded in the last two months, was premature. I think Waller realized this and dialed back his comments in his speech yesterday. Unlike in November, he didn’t suggest rates could be cut within “months.” Three of his quotes,

“The data we have received in the last few months is allowing the Committee to consider cutting the policy rate in 2024. However, concerns about the sustainability of these data trends requires changes in the path of policy to be carefully calibrated and not rushed.”

“I believe policy is set properly. It is restrictive and should continue to put downward pressure on demand to allow us to continue to see moderate inflation readings.”

“This cycle, however, with economic activity and labor markets in good shape and inflation coming down gradually to 2 percent, I see no reason to move as quickly or cut as rapidly as in the past.”

Between Waller’s speech, the better-than-expected retail sales report this morning, and the January Beige Book showing fewer districts with declining activity (4 now vs. 8 in November), the 2-year has risen 18 basis points.

I think it has more to rise. Since every Fed speaker this year has tried to dissuade the market from expecting a March cut and economic data has been better, the still 56% chance of the Fed cutting in March seems like too much. Taking that away would cause the 2-year yield to rise.

This doesn’t change my view of a near-term hard-landing and a big bull market in the 2-year Treasury, but I think the 2-year yield can rise another 20-30 basis points before it falls again. If so, it will be a great buying opportunity.