While the G-20 summit starting this Friday is certainly the week’s top market-moving event as investors and pundits will be closely watching the outcome of the meeting between Trump and Xi for any signs of a thaw in diplomatic relations and trade war rhetoric, just as important will be speeches by the Fed chair Powell and vice-Chair Clarida over the next two days for some much needed guidance on the Fed’s next steps.
The reason: as the chart below shows is that following the recent slump in the market, coupled with rising fears of an economic slowdown in the US next year, traders have sharply cut their expectations for Fed rate hikes in 2019, and from as high as 60bps two months ago, markets now price in just 29bps of rate hikes in the coming year, or in other words just over “one and done”, a sharp disconnect with the Fed’s own dot plot which still anticipates no less than 3 rate hikes next year. In fact, if the Fed does not “guide down” to the market, odds are that risk assets are set for another major negative surprise, pushing stocks even lower.
This is the quandary discussed by SocGen’s Albert Edwards in his latest note, in which he accurately observes that investors are beginning to believe that the Fed is nearing the end of its metronomic tightening cycle.
As shown above, Edwards notes that “market confidence that the Fed will deliver the promised three rate hikes next year is evaporating and recent CFTC data confirms that speculators have begun to unwind their gargantuan short Treasury positions. And yet, despite wild gyrations in the oil price, US CPI inflation expectations remain well anchored around 2% mirroring subdued actual inflation.
But why, Edwards asks, would the Fed end its tightening cycle prematurely when it has been so hawkish in recent months, and follows up with the question answered overnight by Morgan Stanley “Is economic growth about to slump?” (To Morgan Stanley, which expects Q3 2019 GDP to tumble to just 1.0%, the answer is a resounding yes).
At a basis of Edwards’ confusion he refers to a recent speech by Fed Vice Chair Randy Quarles, in which he noted that the relationship between output gaps and inflation has become looser than usual, and then goes on to “sow doubt on whether the Fed should be reassured by the continued quiescence of actual and expected inflation.”
“Something along these lines could be happening to inflation, especially given the important role of expected inflation in the behaviour of actual inflation. Perhaps inflation is just sending a signal of people’s trust in the Fed’s ability to meet its inflation objective. If so, no complaints here. That is a good thing. However, a problem does arise if the Fed remains reliant on inflation as our only gauge of the economy’s position relative to its potential. There are risks in pushing the economy into a place it does not want to go if we limit ourselves to navigating by what might be a faulty indicator. Anchored inflation expectations might mask the inflation signal coming from an overheated economy for a period, but I have no doubt that prices would eventually move up in response to resource constraints. The ultimate price, from the perspective of the dual mandate, would be an un-anchoring of inflation expectations.”
Here Edwards presents two counter arguments: the first showing the NY Fed Underlying Inflation Gauge, which as frequent readers know well, leads CPI by 18 months with an uncanny correlation, and which suggest further upside to core CPI. Here Edwards comments that while he believes the US and eurozone will experience Japanese-style outright deflation in the next global recession “that does not preclude a late-cycle cyclical uplift well above the current 2% target rate.”
On the other hand, the sudden slump in the oil price – which has been driven as much by an unwinding of extreme long speculator positions, as by the fundamentals – is a flashing red signal that headline inflation prints are set to come down sharply in the coming months. In fact, the weakness in the commodity complex – which has caused many a sleepless nights for Goldman which overnight went so far as to “explain” why the market is so very wrong in sending commodities tumbling – goes far wider than just oil, and is a clear indicator that the global economy is slowing sharply, with Edwards showing the commodity correlation to the recent decline in global PMI.
Of course, there is the possibility that the US economy is indeed slowly rapidly into a contraction, with a recession possible as soon as next year. The represent this possibility, Edwards shows recent charts from both David Rosenberg (which shows the latest FIBER economic index which is on the verge of the lowest print since the financial crisis), as well as the latest ECRI index, also set to plumb new multi-year lows.
Edwards proposes that if indeed the US economy is slowing as rapidly as the ECRI suggest, “then we might indeed find that the Fed has already overdone the tightening and is now forced to stop. That is exactly what the market is beginning to think but not what the Feds rhetoric to date suggests. Indeed it may continue tightening and hard-land the economy in 2019, far sooner than any market participants expect.”
As a final point, Edwards references a report which we discussed this past June by SocGen’s Solomon Tadesse, in which he showed that the Feds monetary tightening from the QE-implied rate bottom was already close to what would historically trigger a recession.
Edwards reminds us that back in May, Solomon wrote that “we expect an additional 75bp from the current level, which translates into about three Fed hikes” to which the permabearish SocGen analyst writes that if the Fed indeed stops tightening after the December hike, “Solomon will be spot on and win my forecaster of the decade award!”
Which brings us to the $64 trillion question asked by Edwards: while the Fed will note that implied inflation expectations have dipped below 2%, mainly on the oil price slump, is it really going to take its foot off the brake pedal as investors increasingly seem to think?
While he has no answer at this point his advise is to listen to the fForward guidance at the December Fed meeting: “it could prove crucial in determining whether the current equity correction turns into a slump.“
Of course, if much anticipated “Powell put” fails to make even a thinly veiled appearance, or if Powell remains steadily hawkish in his outlook, prepare for much more pain as stocks realize that the Fed will not deviate from its plans for 3 more rate hikes in the coming year, if only to demonstrate that it is “independent” and will not comply with Trump’s increasingly frequent demands that the Fed put its tightening cycle on hold (or better yet, launch QE4).
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