US

What did the Fed tell us at the last FOMC meeting?  The FOMC hiked the Fed Funds target range to 2.25-2.50%, as expected.  We also got a dovish shift in the Dot Plots, but the overall message was clearly not as dovish as markets were expecting.  Powell said balance sheet reduction is on auto-pilot, dashing hopes for some flexibility.  Most importantly, Powell seemed to put little weight on recent equity market movements, supporting our view that there simply is no Powell Put.

What are markets telling us about the Fed?  Despite Powell’s upbeat view on the economy, markets are saying that they think the Fed is making a mistake.  That is, the Fed is too upbeat on the economy and so will continue to hike and likely push the US economy into recession. 

We've been puzzled by the dollar's recent performance, but it seems to be taking its cue from the bond and equity markets for now.  That is, recession risk is seen as high and that is totally dollar-negative as the budget deficit would blow out and the Fed would cut rates.  We don't agree with this assessment about recession but that's what markets are pricing in.

Market expectations for the early 2019 FOMC meetings are low.  According to Bloomberg’s World Interest Rate Probabilities (WIRP), the odds of a hike on January 30 are a miniscule 2%, while March 20 is a bit higher at 19%.  By signaling one fewer hike next year, it seems unreasonable to expect another hike so soon in the following quarter.  The May 1 and June 19 FOMC meetings become more interesting, especially if the US economy remains firm in Q1. 

The implied yield on the January 2020 Fed Funds futures contract is currently around 2.55%, up from the 2.5% post-FOMC trough.  That was the lowest since May 30 and down sharply from a peak near 2.95% on November 8.  With effective Fed Funds likely to move to around 2.40% after this most recent hike, this current implied yield suggests that less than one hike is being priced in for 2019.  Furthermore, the Fed Funds market is pricing in potential rate cuts in 2020.

A portion of the US yield curve inverted in Q4.  While this is not the typical inversion that presages a recession, markets are nevertheless on heightened alert. 

There’s no doubt that the US yield curve has flattened significantly over the past couple of years.  The 2- to 10-year spread is currently the lowest of the three spreads at around 10 bp, the lowest post-crisis level and nearly at inversion.  The 3-month to 10-year spread, which the San Francisco Fed has shown to be a better predictor, is by comparison at 38 bp and is getting closer to inverting. 

This US yield compression comes even though the US economy remains relatively strong in Q4.  Stronger than expected November retail sales and IP data boosted the Atlanta Fed’s GDPNow Q4 growth forecast to 3.0% SAAR from 2.4% previously.  Surprisingly, the New York Fed’s Nowcast was steady at 2.4% SAAR despite this latest batch of strong data. 

The Fed has come under unprecedented political pressure in 2018 to stop hiking rates.  At the December press conference, Powell pushed back against potential interference, stating rather clearly that political considerations play no role in policy.  He added that nothing will deter the Fed from doing the right thing.  If the Fed continues to hike in 2019 as we expect, criticism of the Fed will likely continue.  On a technical note, the Fed will now hold press conferences after every meeting.  It will continue to issue its Dot Plots and forecasts every other meeting. 

Michelle Bowman was recently confirmed as a member of the Fed’s board of governors.  She brings the total number of Dot Plot contributors up to 17.  As 2019 begins, that group is made up of five members of the board of governors (Powell, Clarida, Quarles, Brainard, Bowman), five voting regional Fed presidents (Williams, Bullard, Evans, George, Rosengren), four alternates (Harker, Kaplan, Kashkari, Mester), and three non-voters (Barkin, Bostic, Daly).  Governor nominees Goodfriend and Liang still need to be confirmed by the Senate before all 19 contributors are fully represented in the Dot Plots.

Bottom line:  We continue to believe that markets are underestimating the Fed’s capacity to tighten in 2019.  We see at least two hikes, perhaps more.  We also believe the dollar rally is intact, but that it may take some time before the markets adjust their Fed outlook to reflect a still-robust US economy that needs further tightening.

Eurozone

The ECB announced that QE will end this year at its December meeting.  It also reiterated its intent to start hiking rates after next summer and added new forward guidance that balance sheet reinvestment would end after rates have started to rise.  The ECB warned that risks were moving toward the downside but did not change its official balance of risks.

New staff forecasts were also released that marked down the growth and inflation outlooks modestly.  Given how poorly the data have come in Q4, there are downside risks to these forecasts.  PMI readings for France and Italy suggest that two of the largest eurozone economies will enter 2019 teetering on the edge of recession.  If weakness continues into 2019, the ECB will have to seriously consider changing its official balance of risks.  This would add to market doubts that the ECB can actually start to lift rates in 2019.  Furthermore, weakness in the peripheral banking sectors is forcing the ECB to contemplate another Targeted Long-term Refinancing Operations (TLTRO) in 2019.

Draghi’s term at the helm of the ECB concludes at the end of October 2019.  He has seen and accomplished much during his single 8-year term.  However, he will likely hand off the decision to hike rates to his successor even as the eurozone economic outlook is deteriorating.  Some, like us, would argue that the ECB may have missed its chance to hike when the eurozone economy was on firmer footing.

Who will replace Draghi?  Bundesbank President Jens Weidmann would seem to be an obvious choice.  Yet there are reports that Germany is pushing to have one of its own replace Jean-Claude Juncker as head of the European Commission (EC).  As such, Germany would have to accept a non-German at the head of the ECB.

More importantly, who will replace Angela Merkel?  She has stepped down as leader of the Christian Democratic Union (CDU).  While she plans to serve out her full term as Chancellor, she may not be able to do so and faces challenges from both the right and the left.  Merkel is considered to be the leader of an inclusive Europe and so her replacement will likely set the tone for Europe going forward.

It’s worth remembering that the ECB has never been headed by a German national.  Since its inception, the ECB has been led by Wim Duisenberg (Netherlands), Jean-Claude Trichet (France), and Draghi (Italy).  Other names being bandied about are Benoit Coeure, Philip Lane, Erkki Liikanen, and Francois Villeroy de Galhau.  

The EU will reportedly hold off on starting excessive deficit procedures against Italy.  Reports suggest that the two sides have accepted Italy’s compromise deficit equal to -2.04% of GDP next year.  EU officials noted, however, that the solution is not ideal and that the budget still raises concerns.  However, it’s clear that both sides made some compromises in order to avoid roiling the markets.

France now replaces Italy on the list of fiscally irresponsible eurozone countries.  President Macron backed down in the face of the Yellow Vest protests.  Not only did he rescind the planned fuel tax, but Macron announced new spending measures and tax cuts.  The budget deficit was already forecast at -2.8% of GDP in 2019, and this fiscal stimulus will likely push it over the -3% threshold.  If the economic slowdown worsens, then France’s deficit could easily approach -4%. 

UK

Prime Minister May called off the Parliamentary vote originally planned for December 11.  Whilst surviving the Tory leadership challenge, May must now gather support for her Brexit plan.  The math says that May still doesn't have the votes to pass it.  She traveled to Brussels this month to ask EU leaders for better terms regarding the Irish backstop, but to no avail as it was basically “take it or leave it” from the EU.

Clearly, the odds of a no-deal Brexit are rising.  Some senior European officials have said that minor details may be modified but wholesale changes are out of the question.  We do not think the EU will make enough concessions to change the math.  Parliament goes on recess December 20 and returns January 7.  May hopes to hold the vote during the week of January 14.  She has ruled out any extension of this deadline, as well as a second referendum.

Opposition Labour has sharply criticized May but has yet to call a no confidence vote in the Tory government.  We cannot rule this out, nor can we rule out Labour somehow coming to power if we get a no deal Brexit and fresh elections are then called.  Quite simply, this combination would be a worst-case disaster for the UK.

The Bank of England must remain in wait and see mode until March 29, when the UK exits the EU, deal or no deal.  The BOE recently set forth a possible no-deal scenario in which the UK economy contracts 8% and sterling plunges 25%.  Governor Mark Carney’s 8-year term was originally set to end June 30, 2021 but Carney planned to step down by mid-2019.  He has since agreed to stay on until January 2020 in order to see the UK through Brexit.

Japan

Japan’s economy struggled in Q3 under the weight of natural disasters.  Can it bounce back?  Q3 GDP contraction was revised to -2.5% SAAR from -1.2% previously and -2.0% expected.  The main drivers were softer private consumption and business spending, but distortions due to natural disaster have to be factored in.  There are downside risks from the planned consumption tax hike from 8% to 10% in October 2019.  The IMF forecasts Japan to grow 0.8% in 2019 vs. 1.4% in 2018. 

Soft data overall in H2 2018 have led the Bank of Japan to underscore its commitment to maintain stimulus until 2021.  It has committed to Quantitative and Qualitative Monetary Easing (QQE) with Yield Curve Control (YCC) since September 2016, when it modified the previous incarnations of QQE and QQE with a Negative Interest Rate.

QQE with YCC commits the BOJ to control the yield curve with a negative interest rate at the short end and with bond purchases to keep the 10-year JGB yield near zero.  The BOJ also committed to allowing inflation to overshoot its 2% target.  YCC is now the primary policy goal and so the BOJ is likely to continue tweaking its bond purchases as needed across the curve to keep rates within the targeted ranges.

Governor Haruhiko Kuroda’s 5-year term ends in April 2019.  He has presided over the entirety of Prime Minister Shinzo Abe’s “Abenomics” experiment, and reports suggest Kuroda is favored for a second term.  The BOJ is expected to maintain current stimulus policies until at least 2021, the earliest that inflation is expected to reach the 2% target.

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January 2019. IS-04549-2019-01-02