After an eventful Q1, it looks like Q2 will be more of a “wait and see” period that could eventually end in fireworks from a variety of sources. The Fed paused in March, as expected, and so all eyes are on the June FOMC meeting. What will the Fed do then? Will the US economy bounce back from Q1 softness? Will the US yield curve inversion last? Elsewhere, Brexit has been delayed but negotiations will remain difficult. Will the UK crash out of the EU without a deal? Lastly, markets will be keenly watching the economies of China, eurozone, and Japan for signs of a rebound.
The Fed delivered another dovish surprise in March. We are maintaining our broad macro views for now, which are dollar-positive, equity-positive, and bond-negative. However, we acknowledge that excessive Fed dovishness will surely test our views.
As expected, the Fed left rates steady last month. What was unexpected was that the Dot Plots shifted down to show the median forecast now sees no more hikes this year instead of the two implied in December. However, the median forecast still sees one more hike next year that would take the Fed Funds rate to the median longer-term rate, which remained steady at 2.75%.
The Fed also announced changes to its balance sheet runoff. The Fed will slow the reduction in its US Treasury holdings from a maximum of $30 bln per month to a maximum of $15 bln starting in May. Its Treasury runoff will be halted altogether at the end of September. However, The Fed will continue to allow its agency holdings to decline by up to a maximum of $20 bln per month.
The Fed also cut its growth forecasts. It sees growth this year at 2.1% vs. 2.3% in December and growth next year at 1.9% vs. 2.0% in December. Yet Powell continued to say that the recent slowdown is temporary. Why, then, did the Fed revise its growth and interest rate forecasts so much? What the Fed is doing implies much more concern about the US economy than what the Fed is saying.
The US economy has slowed sharply in Q1, but that should be no surprise. The shutdown is clearly causing distortions to the data. The situation is further complicated by the fact that Q1 over the last several years typically softens before rebounding in Q2. Faulty seasonal adjustment is often blame but these factors have yet to be addressed fully.
The Fed’s second dovish surprise in a row was meant to calm markets. However, we think it will likely do just the opposite. Markets often need to see confidence emanating from policymakers to feel confident as well. How can the Fed justify moving from “a long way from neutral” back in the fall to the current stance that rates may go up or down? We simply do not believe the fundamental picture has changed that much.
The shift belies the message the Fed has been trying to emphasize all along, that the US economy is in good shape. And that goes to the heart of the Fed’s messaging problem. If the economy is doing so well, why did it signal no more hikes at all this year? It’s “patience” and “flexibility” mantra has always been predicated on the data itself.
Previously, we felt that the Fed’s dovish shift amounted to a Powell Put that was very positive for US equities. That, coupled with what we saw as underlying strength in the US economy, should have kept US equities moving higher. This scenario is still likely, but the dramatic change in the Fed’s messaging will make it more difficult. The market is left to wonder, “What does the Fed know that we don’t?” Thus, it all comes back to the data.
While we remain bullish on the dollar due to our underlying optimism regarding the US economy, this too will be tested. What’s driving our ongoing dollar bullishness is that as dovish as the Fed has shifted, other major central banks have also shifted in the same manner. The ECB added to stimulus at its March meeting, while the BOJ has signaled it is also ready to add stimulus if the economy weakens. The BOE is going nowhere until Brexit uncertainty clears up.
Interest rate differentials and monetary policy divergences still favor the dollar, at least for now. But FX markets run on expectations and if the market starts to increase its expectations of Fed easing, then that will be dollar-negative. Again, it will all come back to the data.
The bond market is the toughest nut to crack. Despite full employment in the US and signs of rising wages, rates at the long end of the US curve continue to drop and the 3-month to 10-year US curve inverted for a week or so before moving back into positive territory to start the quarter. Studies suggest that a sustained inversion of three months (give or take) would likely herald a US recession in the next 6-24 months.
We have long felt that the game-changer for the dollar would be the next US recession. The Fed would cut rates aggressively even as the fiscal deficits blew out. Interest rate differentials would no longer be moving in the dollar’s favor, while ballooning deficits and debt issuance would make it harder to attract the necessary capital to finance those deficits.
It would seem then that the bond market holds all the keys. For now, we our maintaining our bullish equity and dollar calls and bearish bond call. If the US yield curve inversion is sustained, then that would likely spell doom for the current US equity market rally since shares are not pricing in recession risk now. It would also most likely doom the US dollar due to the Fed’s reaction function. However, this may be offset from time to time by pure risk-off dollar demand, as we have seen from time to time this year.
A US recession has never been our base case for 2019. However, the signals being sent by the US yield curve cannot be ignored. As of this writing, the Fed Funds futures market has fully priced in one cut by January 2020 and another by November 2020. We disagree with this path but once again, it will all come down to the data in the coming months.
It’s clear that the Q3 slowdown was not temporary, as policymakers had hoped. Rather, Q4 growth slowed further and that weakness has carried over into 2019. March PMI data showed Germany and France slipping closer to recession, while the overall eurozone PMI readings suggests a growth rate of 0.2% q/q in Q1.
At its March meeting, the ECB recognized this new reality. It announced a new TLTRO for September and pushed out its forward guidance for rate hikes into 2020. Growth and inflation forecasts were cut, but reports emerged after the meeting that some on the ECB thought that the bank was still being too optimistic.
Mario Draghi’s term as ECB president ends in October. There has been much speculation as to who his likely successor is; that person will inherit a sluggish economy and will have the difficult task of dealing with a further slowdown even as rates are already at or below the zero bound. It is hard to imagine another ECB president being as aggressive as Draghi has been. Yet the incoming chief will have to be prepared to undertake further easing if needed (which seems likely).
European Parliamentary elections will be held May 23-26. There are concerns that the populist parties will expand their presence. However, the more immediate problem lies with the UK. There could be significant legal complications if the UK were to take part in these elections even though it has one foot out the door. Much will depend on how the UK navigates these next few key weeks.
Spain will hold general elections April 28, followed by local and regional elections May 26. The center-left minority government led by the Socialists simply could not survive after its budget was soundly rejected. Polls show them gaining support and while they may be the largest party, the Socialists are unlikely to win a majority and we are back to square one.
The UK House of Commons narrowly voted to block a no-deal Brexit. The 313-312 vote to pass the so-called Cooper Bill couldn’t get any closer. It is now being debated in the House of Lords, and reports suggest it will likely pass. The bill states that if no deal is in place by the Article 50 deadline, then the government must ask the EU for an extension rather than crash out without a deal.
Meanwhile, Prime Minister May has reached across the aisle to come up with an acceptable deal. Recent talks between May and Corbyn have been said to be “constructive” and will be continued. Taken together, these recent developments have fed into market consensus that there are lower odds of a no-deal Brexit. We concur and believe that the base case remains some sort of soft Brexit with a likely delay.
We cannot rule out fresh elections. May’s overtures to Labour have reportedly infuriated the hardline Brexit camp in her Tory party. The last general elections in 2017 saw the Tories lose their majority, requiring them to seek out the support of the Democratic Unionist Party (DUP). Yet polls suggest the Tories are more vulnerable than ever, and so fresh elections would bring big risks that should be avoided. We do not think markets would take kindly to a Labour government led by Corbyn.
The UK economy is slowing. GDP growth is forecast by the IMF at 1.5% in 2019 and 1.6% in 2020 vs. 1.4% in 2018. GDP rose 1.4% y/y in Q4, while monthly GDP figures show the 3-month y/y growth slowing to 1.3% in January. Other monthly data suggest further deceleration in Q1. As such, we see some downside risks to the growth forecasts.
The Bank of England has signaled a desire to continue tightening policy, but we see no clear-cut justification for it right now. The next policy meeting is May 2 and no change in policy is expected then. The Short Sterling futures strip shows that a hike is fully priced in by December 2020. After that one, the next hike is fully priced in by December 2022. Of course, the BOE rate path really depends on how Brexit takes shape.
The economy has been slowing, while inflation is nowhere near the BOJ’s 2% target. Governor Kuroda recently pledged more monetary stimulus if necessary. However, we think policymakers will wait to see the impact of the October consumption tax hike before easing further. Q1 ended on a soft note. Japan’s manufacturing PMI slipped under 50 in February and remained there in March.
Kuroda’s five-year term ends in April. Prime Minister Abe has already nominated him for another term. This is hardly a surprise, as Kuroda has been instrumental in implementing one of the Three Arrows of Abenomics and we would not expect any deviation from this. At the same time, the government also nominated Masazumi Wakatabe to be Deputy Governor. He is a professor at Waseda University and has been an advocate of aggressive monetary easing.
The BOJ recently downgraded its assessment of the economy, and the government followed suit. While both blamed global weakness, the upcoming consumption tax hike will be a real test. The last time the tax was hiked in 2014, the economy suffered, and the BOJ was forced to inject more stimulus.
State and local elections are due in April. The Liberal Democratic Party under Abe remains popular, and there are unlikely to be any serious challenges from the opposition anytime soon. Abe was just reelected leader of the LDP for this last three-year term in September 2018 and so he is likely to remain Prime Minister until 2021.
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January 2019. IS-04549-2019-01-02