In a much anticipated move last week, the Federal Reserve (Fed) increased short-term interest rates by 25 basis points (bps). The Fed also outlined parameters for shrinking its $4.5 trillion balance sheet. Once the process begins, it is expected to take at least four years to reduce the balance sheet by approximately $2-2.5 trillion.
While the Fed provided significant news, the largest market moving activity in the U.S. occurred before the Fed announcement as a weak retail sales report and a disappointing inflation report caught the bond market off guard. Retail sales for May fell 0.3% after economists predicted sales to hold steady at previous amounts. The CPI fell by 0.1% to bring the annual increase in inflation, excluding food and energy, to 1.7% from an average annual increase over the past decade of 1.8%. The fall has inflation trending lower from the Fed's target of 2%.
Concerns about inflation expectations should be watched closely in the months ahead as global asset prices would be supported by a modest amount of inflation and real growth. The Fed has been working to normalize monetary policy in a world that still has a significant amount of debt trading with negative interest rates and most developed countries are more concerned about deflation. The Fed would like to see the yield curve (the difference between short- and long-term interest rates) at a steady level as it normalizes monetary policy; however, the yield spread between 2- and 10-year Treasury yields has been compressing this year.
I will closely be watching two indicators for warning signs for future economic growth: the yield curve and credit spreads. The flattening of the yield curve is worth watching because if it continues to flatten, the road ahead for the economy and stocks could become more challenging. Credit spreads are trading at the tightest level in the last decade and have seen very little volatility.
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