Fed policy remains the single biggest driver for global markets. Next up is the US-China trade war. The outlook for both of these drivers should become clearer in Q3, but markets will have to wait.
We continue to believe the Fed’s ongoing dovish shift is positive for US equities. That, coupled with what we view as underlying strength in the US economy, should keep US equities moving higher. Of course, this remains subject to developments on the global front, especially with regards to the ongoing trade tensions with China and other major US trading partners.
We remain negative on US bonds. Again, US yields are reflecting a very pessimistic outlook on the US that we do not think is justified. The yield curve inversion should end as global uncertainties clear up in the coming weeks. We anticipate a bearish steepening of the US curve in response to better US data. But again, markets will have to wait.
We remain bullish on the dollar due to our underlying optimism regarding the US economy. Interest rate differentials and monetary policy divergences still favor the dollar, at least for now. Again, we stress that aggressive Fed rate cuts should not be viewed as a done deal. It is data-dependent. Yet despite the market’s uber-dovish take on the Fed, the dollar has held up relatively well.
What’s also 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, if not more so. The European Central Bank (ECB) added stimulus at its March meeting by announcing a new Targeted Longer-term Refinancing Operations (TLTRO) and now appears to be teeing up a rate cut before year-end. Bank of Japan (BOJ) Governor Kuroda has signaled he is ready to add stimulus as needed. BOE meets is going nowhere fast given Brexit risks. Reserve Bank of Australia (RBA) and Reserve Bank of New Zealand (RBNZ) and RBNZ are already cutting rates, while the market sees the Bank of Canada (BOC) joining them by year-end.
Fears of a recession have been running strong in recent months. Some of those fears eased after the US suspended the tariff threat on Mexican imports. Perhaps they will ease further as the US and China restart trade talks.
We think recent US retail sales data were a game changer. With strong May sales and significant upward revisions to April, Q2 is now looking pretty good. Atlanta Fed GDPNow has Q2 growth at 2.1% SAAR, up from 1.4% last week. NY Fed Nowcast has Q2 growth at 1.4% SAAR and Q3 growth at 1.3% SAAR. While a slowdown from Q1 (3.1% SAAR) was to be expected, markets will remain sensitive to signs of a larger than expected drop-off.
As expected, the Fed left rates steady in June. What was unexpected was that eight FOMC members now see rate cuts this year as appropriate. In March, that number was zero. In 2020, nine members see cuts as appropriate. The end-2019 median Fed Funds remains at 2.375%, but the end-2020 median dropped to 2.125% from 2.6125% in March. Lastly, the median longer run Fed Funds rate is now at 2.5% vs. 2.75% in March. This was about as dovish as the Fed could be without actually cutting rates. As things stand, a 25 bp cut July 31 now appears likely.
The statement language was different as the Fed dropped its “patient” approach. Instead, the Fed pledged to “act as appropriate to sustain the expansion.” We also got the first dissent under the Powell regime, with one FOMC member (Bullard) calling for a rate cut. The Fed tweaked its growth and inflation forecasts modestly, but not by enough to justify this latest dovish step.
After the FOMC decision, implied yields across the Fed Funds futures strip fell. The January 2020 contract is now at 1.63%, which is fully pricing in three cuts this year. The January 2021 contract is now at 1.30%, which is fully pricing in one cut next year and part of a second. This seems way too aggressive to us. These are not insurance cuts, these are recession cuts.
Indeed, St. Louis Fed President Bullard recently expressed doubts about the need for a 50 bp cut. Fed Chair Powell noted that it is important that the Fed not overreact in the short-term, and that it continues to weigh whether uncertainties call for easing. While we would struggle to classify these comments as hawkish, they were certainly less dovish than what markets had hoped for.
What is the underlying signal? We believe the Fed is prepared to cut rates in July. However, it seems clear from these most recent Fed comments that it is starting to push back a bit on the market’s ultra-dovish take on its policy. We do not believe the Fed will meet market expectations of 75 bp of easing this year and nearly 50 bp next year. Neither apparently does the Fed. When markets readjust expectations, that is when the dollar should gain more traction.
Through much of Q2, press reports and official comments suggested that a US-China trade deal was well within reach. In May, President Trump accused China of reneging on previously agreed issues. The US reinstituted the tariffs that had been suspended while preparing to extend those tariffs on another $300 billion worth of Chinese imports. Trump doubled down on his threats and said that those extra tariffs would be levied if Xi did not meet him at G20.
There appears to be a thaw in US-China relations. The US will reportedly suspend those planned tariffs while the two sides resume talking. US officials have downplayed the chances of a near-term breakthrough, but at least the threats have stopped (for now). Indeed, Treasury Secretary Mnuchin said he is “hopeful” and estimated that a deal is 90% complete. Our base case scenario remains that a compromise is struck late in Q3.
The March 29 deadline for Brexit was extended several times before it became clear that the two sides were at an impasse. The deadline has now been extended to October 31. It is still unclear what form Brexit will take.
What happens next with Brexit depends in large part on who becomes the next Prime Minister. There are only two candidates left after the MP vote, and Boris Johnson remains the frontrunner. Voting went to a full vote of Conservative party members June 22, with the next Prime Minister to be announced July 22.
The Brexit plot thickens. Senior Tory MP Kenneth Clarke said he would be prepared to bring down a Johnson-led government to prevent a no-deal Brexit. This view was echoed by Defense Minister Tobias Elwood, who predicted that around a dozen Tory MPs could support a no confidence motion with the same aim. Elsewhere, reports suggest the opposition Labour party is preparing to table a no confidence motion within 24 hours of a new Prime Minister being chosen in July.
UK data continues to weaken as the Brexit saga drags on. While the Bank of England (BOE) continues to see a need to tighten policy, nothing is likely until after October 31. However, the markets do not believe the BOE. The implied yield on short sterling futures suggest that the next rate hike does not become fully priced in until Q1 2024.
BOE Carney’s extended term ends in January 2020. Theoretically, this will only give Mark Carney a couple of months to move on policy after Brexit. In practice, we believe Carney will hand the decision to hike over to his successor. Simply put, it seems foolish to try and push through a rate hike in the final months of his term when the full impact of Brexit likely will not have been felt yet. Chancellor Philip Hammond has started the search for Carney’s replacement.
ECB President Draghi rides off into the sunset on October 31. Christine Lagarde, who was nominated to lead the European Central Bank (ECB), makes for an interesting and ultimately excellent choice as Mario Draghi’s successor at the ECB. She is pragmatic and was able to push the International Monetary Fund (IMF) into taking a big role in fighting the eurozone crisis. In terms of monetary policy, we believe she would be as activist as Draghi is. There were always doubts about whether other candidates, like Jens Weidmann, the head of Germany’s Bundesbank, would be willing to do “whatever it takes.” We think Lagarde would pretty much be Draghi 2.0.
At the ECB’s annual forum in Sintra, Draghi noted that “additional stimulus will be required” if the economic outlook doesn’t improve. Draghi also noted that further rate cuts remain in the ECB’s toolkit, as does QE. He added that renewed asset purchases would likely require raising self-imposed limits on how much the ECB can buy.
ECB officials said that rate cuts would be the primary tool for the next round of stimulus. We thought Draghi might be setting the table for his successor to act but it’s quite possible that Draghi takes that step in order to make it easier for the next head to act again if needed. The remaining ECB meetings left for Draghi are July 25, September 12, and October 24. A lot will depend on the data, but we think he may go out with a bang.
Draghi’s successor will inherit a sluggish economy with falling inflation. The ECB forecasts growth of 1.2% in 2019 followed by 1.4% in 2020. PMI readings suggest the economy is stabilizing a bit in Q2 after the Q1 slowdown. However, Germany is getting hit particularly hard by the slowdown in mainland China. This is dragging overall eurozone growth lower. Inflation and inflation expectations continue to fall, making a policy response all the more likely.
Tensions between Italy and the EU are likely to pick up over the summer. The ostensible drama will involve the 2020 budget process that kicks off this fall. We expect a repeat of last fall’s drama over the 2019 budget, when the threat of excessive deficit procedures finally got Italy to back down from planned fiscal easing. What’s different now is that the League’s Matteo Salvini may be emboldened by the European Parliamentary elections to stand up to the EU.
The economy is softening ahead of the planned consumption tax hike in October. That hike has been delayed twice already but officials have made it clear that barring some sort of Lehman-type financial crisis, the tax will be hiked from 8% to 10%. The hike was originally scheduled for October 2015 but it was delayed to April 2017 and then to October 2019.
BOJ Governor Haruhiko Kuroda has pledged to add more stimulus as needed. We fully expect more stimulus after the consumption tax hike. When this tax was last hiked in 2014, the economy went into recession. The IMF forecasts 0.8% growth this year and 0.9% in 2020, virtually unchanged from 0.8% in 2018.
Upper house elections will be held in July. Half of the 242 seats will be elected. Currently, the ruling coalition has a solid majority with 148 seats. Prime Minister Shinzō Abe and his LDP remain popular and so we expect the coalition to maintain its majority. There was speculation that snap lower house elections would be called at the same time, but this does not appear to be the case.
Prime Minister Abe has attempted to cultivate good relations with President Donald Trump. However, we doubt it will be enough for Japan to escape Trump’s eventual glare. Planned auto tariffs based on national security concerns were delayed six months until November. For now, Japan is on the back burner as the US grapples with China. Once that is resolved, US attention will likely turn back to Japan and Europe.
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