Markets edge lower after comments by 2 Fed officials

Dow finished down 176, decliners over advancers 5-4 & NAZ declined 86.  The MLP index rose 4+ to the 224s & the REIT index fell 3+ to the 446s.  Junk bond funds were flattish & Treasuries continued with heavy selling.  Oil was fractionally higher to the 115s & gold was up 3 to 1852 (more on both below).

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The Federal Reserve is poised to start shrinking its $8.9T balance sheet, deploying one of its lesser-known tools as it seeks to tame the hottest inflation in a generation.  In a plan outlined at the central bank's May meeting, policymakers said they will begin winding down the balance sheet on Jun 1 at an initial combined monthly pace of $47.5B, a move that will further tighten credit for US households.  They will increase the runoff rate to $95B by Sep, putting the Fed on track to reduce its balance sheet by about $3T over the next 3 years.  The Fed's balance sheet, which consists mostly of bonds & other assets that it has purchased, nearly doubled in size during the pandemic as the Fed bought up mortgage-backed securities & other Treasuries in order to keep borrowing cheap.  Policymakers say the portfolio runoff will work in tandem with interest rate increases to bring prices down by slowing growth & tightening credit.  The Fed voted to raise rates by a ½-basis point in May & has all but promised that similarly sized hikes are on the table at upcoming policy meetings in Jun & Jul.  While it's unclear how effective reducing the balance sheet will be in fighting inflation, policymakers have suggested they are optimistic it will work to bring prices down.  "Although estimates are highly uncertain, using a variety of models and assumptions, the overall reduction in the balance sheet is estimated to be equivalent to a couple of 25-basis-point rate hikes," Fed Governor Christopher Waller said.  The question now is whether the Fed can successfully engineer the elusive soft landing — the sweet spot between tamping down demand to cool inflation without sending the economy into a downturn.  Hiking interest rates tends to create higher rates on consumer & business loans, which slows the economy by forcing employers to cut back on spending.  Fed Chair Jerome Powell has acknowledged there could be some "pain associated" with reducing inflation & curbing demand but has pushed back against the notion of an impending recession, identifying the labor market & strong consumer spending as bright spots in the economy.  Still, he has warned that a soft landing is not assured.

Fed starts shrinking $8.9T balance sheet to combat sky-high inflation

San Francisco Federal Reserve Pres Mary Daly said she backs raising interest rates aggressively until inflation comes down to a reasonable level.  Those moves likely would entail multiple 50 basis point hikes at coming meetings, then a possible rest to see how the central bank policy tightening is combining with other factors to impact the massive surge in consumer prices.  “We need to that expeditiously, and I see a couple of 50 basis point hikes immediately in the next coupe of meetings to get there,” she said.  “Then we need to look around and see what else is going on.”  Daly said she sees some initial signs of a slowing economy & reduced inflation, but will need to see much more progress before the Fed can slow its efforts.  “We aren’t really there yet, so we need to see those data on a slowing economy bringing demand and supply back in balance, and I need to see some real progress on inflation,” she added.  “Otherwise, I would think we just move the rate until we find ourselves at least at neutral and then we look around to see what else needs to be done.”  So far this year, the Fed has enacted two rate increases totaling 75 basis points, including a 50 basis point increase in May.  “I don’t meet anyone, contacts, consumers, anyone, who thinks the economy needs help from the Fed right now,” Daly said.  “I certainly am comfortable to do what it takes to get inflation trending down to the level we need it to be. I really think these inflation numbers have been going on too long, and consumers, businesses and everyday Americans are depending on us to get inflation back down and bridling it.”  How far Daly & the rest of the Fed are willing to go remains to be seen & she said the data will dictate how high rates trend.  Most Fed officials estimate the “neutral” level of their benchmark borrowing rate to be around 2.5%. It currently is targeted in a range between 0.75% and 1%.  Daly said issues such as supply chain backlogs, the war in Ukraine & the China economic reopening after a Covid-related shutdown will be factors on whether inflation has peaked.  If she doesn't see progress, “we need to go into restrictive territory,” she continued.

The Fed’s Mary Daly says rate hikes should continue until inflation is tamed

US manufacturing activity picked up in May as demand for goods remains strong, which could further allay fears of an imminent recession, but a measure of factory employment contracted for the first time in nearly a year.  The Institute for Supply Management (ISM) said that its index of national factory activity rebounded to a reading of 56.1 last month from 55.4 in Apr.  A reading above 50 indicates expansion in manufacturing, which accounts for 12% of the US economy.  US manufacturing activity picked up in May as demand for goods remains strong, which could further allay fears of an imminent recession, but a measure of factory employment contracted for the first time in nearly a year.  The forecast called for the index falling to 54.5.  The survey followed a report last Fri showing consumer spending increasing strongly in Apr.  The ISM survey's forward-looking new orders sub-index increased to 55.1 from 53.5 in Apr.  Manufacturing has been constrained by snarled supply chains, which have been further entangled by Russia's unprovoked war against Ukraine & new shutdowns in China as part of Beijing's zero COVID-19 policy.  The ISM's measure of supplier deliveries slipped to 65.7 last month from 67.2 in Apr.  A reading above 50% indicates slower deliveries to factories.  The survey's gauge of order backlogs rose to a reading of 58.7 from 56.0 in Apr.  News on the inflation front was encouraging.  A measure of prices paid by manufacturers dropped to a reading of 82.2 from 84.6 in Apr, supporting views that inflation has probably peaked.

U.S. manufacturing sector regains speed in May-ISM

Inflation at levels last seen in the 1970s & early 1980s is putting the central bank's credibility at risk, St Louis Federal Reserve Bank Pres James Bullard said, reiterating his call for the Fed to follow thru on promised rate hikes to bring down inflation & inflation expectations.  "The current U.S. macroeconomic situation is straining the Fed's credibility with respect to its inflation target," Bullard said.  Inflation is at more than 3 times the Fed's 2% target, pushed up by the collision of strong consumer demand & constrained supply of labor & parts.  In response, the Fed has raised interest rates by ¾ of a percentage point this year - a pace critics say is far too timid to bring inflation under control quickly.  But today Bullard laid out the case - as he has many times previously - that the Fed has actually tightened monetary policy far more than its actual rate hikes suggest.  Fed Chair Jerome Powell's vow to keep tightening monetary policy until inflation declines in a clear & convincing manner has solidified market expectations for further rate hikes through the year & into next, including ½-point rate hikes at each of the next 3 meetings and a policy rate in a range of 2.75%-3% by Dec.  "The Fed still has to follow through to ratify the forward guidance previously given, but the effects on the economy and on inflation are already taking hold," Bullard said.  "The Fed still has to follow through to ratify the forward guidance previously given, but the effects on the economy and on inflation are already taking hold," Bullard added.

Fed's Bullard: high inflation 'straining' credibility

All told, today marked another strong session for precious metals despite rising Treasury yields & a strengthening $.  Gold futures, meanwhile, increased pennies to finish the session at $1843.  All 3 major US stock indices were down in the PM, while an aggressive selloff across Treasuries pushed yields on 2-7-year maturities up by 11 to 14 basis points each.

Platinum leads precious metals higher as stocks, bonds tumble

Oil futures ended higher as Shanghai eased its COVID-19 lockdown, signaling increased demand for crude.  Traders were also preparing for meeting tomorrow of OPEC+, after a report that the group was considering exempting Russia from its production targets.  West Texas Intermediate crude for Jul rose 59¢ (0.5%) to close at $115.26 a barrel.  Aug Brent crude, the global benchmark, gained 69¢ (0.6%) to settle at $116.29 a barrel.  Shanghai moved to restore full bus & subway service today, as well as basic rail connections with the rest of China.  Still, more than ½ a M people in the city of 25M are still under lockdown or in designated control zones because virus cases are still being detected.  China's zero-COVID policy has resulted in mass lockdowns, with the shutdown of Shanghai, its largest city & a key commercial hub, credited with keeping a lid on crude prices that remain above $100 a barrel in the wake of Russia's invasion of Ukraine in late Feb.  The EU this week agreed on a plan that imposes a partial embargo on imports of Russian crude.  But oil futures lost steam late yesterday after a report that some OPEC members were considering exempting Russia from the OPEC+ oil-production agreement as sanctions & the EU's partial import ban undercut the country's ability to meet its targets.  If agreed, that would clear the way for other producers, including Saudi Arabia & UAE, to pump more crude to make up or Russia's shortfall.

Oil ends higher as Shanghai eases COVID-19 lockdown

Investors are weighing comments (above).  When the Fed sells bonds from its portfolio, that is bearish for bond prices which drives rates higher.  That influence has been absent for several years.  Today there was heavy selling in Treasuries, raising yields sharply.  In addition, more rate hikes from the Fed are coming in the coming months.  While Treasury yields are not high by historical standards, they are new to many investors who have depended on low interest rates.  The REIT index above has been weak for the last 6 weeks on worries about rising interest rates.  Higher interest rates will pinch the economy.

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