We’ve Just Begun

This week we’re all waiting for Jay
To finally come out and say
A quarter is done
And we’ve just begun
To cut, lest the world goes astray

After a wild week of trading last week, with significant back and forth in all markets, we are starting this week with a calmer feel. Friday’s rebound has resumed with today’s trading and risk is back in favor. Equity markets were strong in Asia (Nikkei +0.7%, Hang Seng +2.2%, Shanghai +2.1%) and are firmer in Europe as well (DAX +1.0%, CAC +1.0%, FTSE +1.0%). At the same time, government bond yields have rebounded with 10-year Treasuries up 6bps and German bunds +5bps. Gold is softer, as is the yen and the dollar and generally everybody is feeling better.

At this point there seem to be two market drivers of note that are reinvigorating the optimists; a belief that Chairman Powell will be describing further rate cuts (plural) when he opens the Fed symposium in Jackson Hole on Friday, and the news that Germany’s FinMin, Olaf Scholz, has hinted that Germany could produce a stimulus of up to €50 billion if the country slips into recession. This was made all the more important as the Bundesbank this morning warned that after negative growth in Q2, Germany looked like it was going to experience negative growth in Q3 as well, leading to that recession in question. Further pressure in Europe was clear as the final July CPI data was released at just 1.0%, 0.1% lower than the initial estimate and adding to the urgency for the ECB to act aggressively next month. However, despite the prospect of further policy ease by the ECB, the euro has rallied slightly, up 0.1%, on the generally better risk outlook.

While the market’s overall optimism is impressive, it appears to me that faith in central banks’ ability to correct every flaw in the economy is misplaced. If we have learned nothing else during the past decade it is that central bankers are always reactive, never proactive, and that they rely entirely on models which no longer appear to represent even a semblance of economic reality. But rely on them they do, and so as we have seen with leadership throughout history, central banks are fighting the last war, not the current one.

At any rate, there is no reason to believe that they are going to change their collective mindset in the near future, so all we can do is try to anticipate what their actions will be, not what they should be.

With that in mind, the key question this week is; what will Chairman Powell tell us on Friday? Futures markets are currently pricing full certainty of a 25bp rate cut and a 20% probability of a 50bp rate cut at the September meeting. Given the strength of US economic data we have seen lately, (Retail Sales +0.7, both Empire State and Philly Fed stronger than expected) as well as the fact that there were two dissents at the July meeting when they cut rates, that seems a bit aggressive. However, the narrative has evolved into the idea that increased globalization has turned the Fed’s mission into a global role rather than a US focused one, given the likelihood that recession elsewhere in the world will ultimately drag the US down as well. The one thing that is becoming clearer by the day is that the rest of the world is sliding into a recession, which in the new zeitgeist implies that the Fed needs to act.

The follow-on question then becomes, if Powell does sound more dovish, how will markets react? Certainly the initial move will be an equity market rally, and in truth, I expect that we will see bonds rally as well. And the dollar? Well here it gets trickier. On the one hand, a more dovish Fed implies the interest rate premium in the US will shrink and the dollar should slip alongside. However, the flipside is that an equity and bond market rally will continue to draw investment into US securities and drive demand for the dollar, offsetting any losses due to lower yields. As I have consistently maintained throughout the entire cycle, the idea that the dollar will fall if the Fed starts easing aggressively is likely misplaced as they will not be doing so in a vacuum. Rather, if the Fed is cutting, you can be sure that everybody else is doing so as well.

Proof of this has been abundant with the ECB ‘threatening’ powerful and impactful action at the next meeting, the Norgesbank halting their rate hiking cycle and the actions of a half dozen EMG central banks (Mexico, Philippines, India, et al.) cutting rates with more in store. In the end, nothing has occurred to change my view that the dollar trends stronger rather than weaker over time.

Data this week is quite limited with just Housing and the FOMC Minutes which means that Friday’s Powell speech will be that much more impactful.

Wednesday Existing Home Sales 5.39M
  FOMC Minutes  
Thursday Initial Claims 216K
  Leading Indicators 0.2%
Friday New Home Sales 645K

So for now, barring any news on the trade front, which seems to have slipped to the back burner, or Brexit, which is there as well, I expect a generally quiet week with a positive risk vibe and a marginally softer dollar. Anticipation of easier policy from Powell is the latest key for markets, but until we hear directly from him, I expect limited activity overall.

Good luck