US economy

After you, Mr Powell


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Three leading central banks hold their final policy meetings for the year this week and at a time when equity and credit markets signal a foreboding outlook for the global economy. It’s important to acknowledge that market stress also reflects a pronounced year-end rush to exit positions and a wider recognition among investors that the good times courtesy of central banks’ easy money are well past us. 

This is perhaps the most worrying aspect of markets at this juncture: the current risk tantrum is becoming ugly, with the potential to hurt confidence in the broad economy. In turn that raises the importance of central bank action, and in that respect among the Federal Reserve, Bank of Japan and the Bank of England only one really matters this week: the mood music from Washington. 

Another tightening is expected (the ninth quarter-point shift higher for the cycle), but the focus for the market is the scope of changes in the Fed’s forecasts for the economy and the path of interest rates for the current cycle. As my colleague Sam Fleming notes in his excellent write-up of what to expect from the Fed on Wednesday, growth remains solid, the unemployment rate is at levels not seen since 1969 and wage growth is picking up.

Still, inflation expectations are dropping (driven mainly by the slump in oil prices) and the recent tightening of dollar liquidity as the Fed’s shrinking balance sheet has weighed on emerging markets, equities and now credit.

At the September meeting, Fed officials sawvia their dot plot  another three rate rises in 2019, pushing the upper band to 3.25 per cent. The bond market thinks 2019 is the year for “one and done” at best by the Fed as the January 2020 Fed funds futures contract implies a rate around 2.60 per cent.

Ian Lyngen at BMO Capital Markets says the meeting statement, economic and rate projections, followed by the latest tidings from Mr Powell “will set the tone for the opening months of 2019”.

“The shifting focus to the downside risks facing the global economy is undoubtedly a space to watch in the remarks from the Fed chairman.”

It is unlikely that the Fed drastically changes the dot plot for 2019, raising the prospect of a negative market reaction. 

Here’s Wrightson Icap’s Lou Crandall:

“The Fed’s dot plot will probably be somewhat less hawkish than it was in September, but it will continue to assume at least some additional rate increases in 2019 and 2020.”

The general thinking is that the Federal Open Market Committee will indicate that two 25 basis point tightenings beckon for 2019 with perhaps an added kicker of lowering its long-term dot from 3 per cent. Keeping two dots in place for 2019, with a long-term target of 2.875 per cent or even 2.75 per cent, would indicate policy is close to neutral.

But a key factor in the Fed’s tightening of policy has been the shrinking of its balance sheet, now running at a maximum pace of $50bn a month. This will continue, and comes as some are calling for the Fed to halt the squeeze on global dollar funding which occurs as it shrinks the balance sheet.

The worry is that the reduction of the balance sheet will continue to hamper the performance of markets and won’t merit a response from the Fed until sentiment has really soured. The status of the balance sheet may well be the most important takeaway for markets from this Fed meeting. 

Neels Heyneke and Mehul Daye at Nedbank say equity markets are being starved of liquidity and note “a strong relationship between the change in Global $-Liquidity (M1) and the performance of the global stock market”.

They add: “Global $-Liquidity leads the global stock market by an average of eight months. If there is no boost to Global $-Liquidity, we expect this relationship to hold. As a result, the risk of further downside potential for stock markets across the world would remain intact.”

Here are a couple of charts that hopefully are not too small for readers on mobile devices.

When it comes to watching markets, it’s not just equities that matter.

One key indicator that worries plenty of investors is a flattening yield curve and there is scope for guidance from Mr Powell when he speaks tomorrow. While the difference between two- and 10-year yields remains positive, at about 0.16 percentage points, we are approaching inversion territory, a relationship that has been a reliable indicator of recession in past cycles. 

As Wrightson Icap note:

“The economic data collectively still justify another rate hike this month and still suggest that additional rate hikes will be appropriate next year but the change in yield curve dynamics is one more reason for the Fed to be more circumspect in offering hawkish policy guidance about the first half of 2019.” 

Any comments on credit and the recent widening in risk premiums would be an important signal that a pause may well arrive early in 2019. 

Fred Cleary of Pegasus Capital sent me an interesting note on Tuesday highlighting how investment grade spreads were around similar levels when the Fed paused in 2000 and 2006.

Sure, the absolute level of yields is lower, but Fred says “sustainable growth rates have close to halved over the same period, from 3-4% down to 1.5-2%”.

As the US economy slows from here, we are about to see how companies with falling cash flows will cover their debts. Market Forces has been warning about credit for some time and this is the big story over the next 12 months.

One area under growing pressure is leveraged loans, an index of which has fallen 2.6 per cent from its peak in late October, in part reflecting the prospect of a Fed pause next year that halts the rise we have seen in floating interest rates. The loan market is still up some 1.6 per cent for 2018 thanks to Fed tightening pushing up floating rates. 

As Citi notes:

“In our view, the weakness is a combination of overall risk aversion widening credit spreads and the waning attractiveness of floating-rate paper. The rates market is pricing in less than one 2019 rate hike, down from 2¼ in early October.”

The concern now is that the liquidation we have seen from investors exposed to the loan sector has only just begun. The credit exit can quickly become very crowded.

At Longview Economics they think:

“A trigger for a less aggressive Fed in 2019 is the sign of further weakness in the leverage loan market  an area that has accounted for a large chunk of credit for companies since 2009.”

So we have a crucial and perhaps defining day looming on Wednesday, and as you read this I’ll be up in the air on my way to JFK. I’m certainly looking forward to being in New York for the FOMC meeting and the fallout. Then I can catch up with family and friends. 

Quick Hits  what’s on the market radar

All quiet on the China stimulus show  Not much for investors hoping for some concrete stimulus measures as Xi Jinping marked the 40th anniversary of Deng Xiaoping’s “reform and opening up” policy. For all the hope of a Fed pause, global growth prospects need China stimulus in the new year as the US tax reform tailwind fades.

The big allocation switch As I recently noted, the pronounced drop in long-dated Treasury yields smacked of a major asset allocation switch out of credit and equities. That’s the message we heard on Tuesday from the latest Bank of America Merrill Lynch survey of asset managers. Global investors’ net underweight position in bonds tumbled 23 percentage points in December to 35 per cent, the biggest change in the history of the survey and the lowest underweight position since the Brexit vote in June 2016.

BoJ and BoE outcomes  Expect a lot less drama.

For the Bank of England, Brexit keeps them firmly on the sidelines. Here’s Marc Chandler at Bannockburn:

“Until Brexit has been cleared up one way or another, the BoE is simply stuck in a wait and see mode. In the event of a no-deal Brexit, it’s hard for us to see the bank hiking rates. Yes, there may be inflationary impulses from a plunging pound, but the recessionary impulses are likely to be even stronger.”

Finally, no one expects the Bank of Japan to signal any change in policy and the terms of its QE, keeping stimulus going well past 2020.

Your feedback

I’d love to hear from you. You can email me on michael.mackenzie@ft.com and follow me on Twitter at @michaellachlan.





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