The market is making its case
The Fed should be slowing the pace
Of interest rate hikes
That nobody likes
As growth has begun to retrace
The emerging narrative is that the Fed needs to stop raising rates before it is too late, or else the global economy is going to sink into a recession. Funnily enough, I think this is one area where many of the glitterati agree with President Trump; Chairman Powell is doing the wrong thing. Certainly, recent equity market activity has been pretty bad, with the overnight sessions showing sharp declines again (Shanghai -1.7%, Nikkei -1.9%, DAX -2.4%, FTSE -2.5%) and US futures pointing to a -1.75% fall on the opening. While the proximate cause of today’s move may be the surprising arrest of the CFO of Chinese telecoms manufacturer Huawei, the reality is that there are plenty of issues that are generating concerns these days.
Clearly the primary concern continues to be the trade situation between the US and China. Monday’s relief rally was based on the fact that there seemed to be a truce. Tuesday’s sharp decline was based on the fact that there were disputes to that message. This morning’s declines have been a reflection of growing concern that the above-mentioned arrest will undermine any chance at trade progress between the two nations. But in addition to the trade story, the background narrative has been that the Fed is raising rates despite growing evidence that the US economy is slowing rapidly. Exhibit A in that story is the housing market, which has seen a particularly weak run of construction and sales over the past six months. Then there is the auto sector, where sales have fallen back from the remarkable heights seen last year. These two industries make up a significant portion of the market’s perception of the economy because virtually everybody has a house and a car, and is aware of what prices are doing there. They have always been seen as a harbinger of future economic activity, so if they are slowing, that bodes ill for the economy at large.
And this is where the dissatisfaction with Powell arises, because he continues to raise rates based on the idea that inflation, while remaining subdued, has the potential to rise sharply unless the Fed tightens policy. They continue to look at the Unemployment Rate of 3.7%, a rate well below any estimates of the Natural Rate of Unemployment, and expect that inflation is going to jump soon. And it might, but so far, that has just not been evident. In fact, the past couple of readings have shown a softer inflation bias, which further adds to the pundit’s angst over Powell.
This commentator is not going to opine on whether the Fed is right or wrong at this time, but I will say that my fear is that all the tools that the Fed (and every other economist) are using to forecast future economic activity are likely not up to the task. There have been massive structural changes to both the economy in general (ongoing improvements in automation across industries) but more specifically, to the way monetary policy works. The aftermath of the financial crisis has fundamentally changed the way the Fed and every other central bank oversees their respective economies. No longer do they adjust reserves to achieve a desired interest rate at a clearing price. Now they simply tell us where rates are and use their powers of suasion to keep them there. And ten years on, the market has built up structures that are now reliant on the new process, so reverting to the old one is no longer an option. My strong concern about this is that these changes are not reflected in the way econometric models are built, and therefore those models do not produce results that are coherent with the current reality.
With that as background, it is easier to understand why there is so much confusion and concern in markets in general. If the Fed is using outdated tools to manage the economy, odds are they won’t work very well. Perhaps this is what the equity markets are pointing out, and have been doing pretty much all year outside the US.
Pivoting to FX, the question is, how will this narrative impact the dollar? Generally speaking, what we have seen is an ongoing risk-off scenario throughout markets, and that has historically been quite beneficial for the greenback. Last night was no exception with Asian currencies experiencing significant declines (AUD -0.9%, NZD -0.5%, CNY -0.6%) while the yen, the other chief beneficiary of risk reduction, rallied 0.4%. We have also seen weakness in CAD (-0.6%), MXN (-0.5%) and BRL (-0.8%). Granted, the CAD story has more to do with the BOC walking back their recent hawkish views, and behaving the way the market wants the Fed to behave. But as long as the Fed seems certain to raise rates come December, and the rest of the world is crumbling, the dollar will find support.
Perhaps we will hear a new tone from the Fed today and tomorrow, as Chairman Powell testifies to Congress today and we hear from both Williams and Bostic with Governor Brainerd speaking tomorrow. The risk is that each of them starts to walk back the hawkish views that have predominated, and reconsider future rate hikes. In that case, look for equity markets to rocket higher, while the market prices out a December rate hike and the yield curve steepens. Also in that case, watch for the dollar to decline sharply. But in the event they maintain their current tone, I see no reason for the dollar to backpedal.
We actually have a bunch of data today as yesterday’s data was delayed due to the day of mourning for President Bush. Today includes ADP Employment (exp 195K), Initial Claims (225K), Nonfarm Productivity (2.3%), Unit Labor Costs (1.1%), Trade Balance (-$54.9B), ISM Non-Manufacturing (59.2) and Factory Orders (-2.0%). It will be interesting to see if we start to get softer data from ISM but I really believe that the market will be far more focused on the Fedspeak and tomorrow’s payroll data than today’s data dump.