Chief economist update: That other Fed policy towards normalcy

Latest data updates indicate that the US economic juggernaut continues to power on.

The ISM non-manufacturing index shot up from 58.5 in August to a higher than expected 61.6 in September - its highest level on record. In addition, the ADP private sector employment report showed persistent labour market strength with another 230,000 gained in September.

This provides a positive lead to Friday night's non-farm payrolls report for September where the unemployment rate is expected to remain at 3.9% (just a tick above the 18-year of 3.8% recorded in May).

These reports provided a timely backdrop and confirmation to Fed chair Powell's words before the National Associate for Business Economics,

"I am glad to be able to stand here and say that the economy is strong, unemployment is near 50-year lows, and inflation is roughly at our 2 per cent objective ... This forecast is not too good to be true" but "is testament to the fact that we remain in extraordinary times" and "amount to a better world for households and businesses which no longer experience or even fear the scourge of high and volatile inflation."

Read: strong growth with stable and low inflation.

But with the yield on 10-year US Treasury bonds surging by 12 bps to 3.18% - the highest rate since mid-2011 - overnight, the bond market doesn't seem to be completely buying this strong growth, stable and low inflation scenario. Eco 101 dictates that strong growth will ultimately lead to higher inflation.

Ergo, the Fed would need to be more aggressive in raising the fed funds rate. At the conclusion of its September FOMC meeting, the Fed's dot plots indicated another three more interest rate hikes in 2019, on top of another one in December this year.

But the jump in bond yields does not make sense. This is because the Fed's September forecasts show GDP growth slowing over the next three years and inflation remaining within its target.

So what gives? The surge in long bond yields could be due to the twin of the Fed's normalisation policy - its balance sheet unwind.

The Fed started to shrink its balance by US$10 billion a month in October, November and December last year, which then accelerated by another US$10 billion every three months. This month, the Fed is slated to reduce its holdings by US$50 billion a month. That's US$600 billion a year buy order vapourised from the bond market.

This coincides with the increased bond supply. The US Treasury expects to issue an extra US$1.3 trillion of bonds this year to finance Trump's tax cuts and fiscal spending.

Read more: Jerome Powell
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