The U.S. rate market is putting “paid” to the latest narrative on inflation as it continues to discount even deeper rate cuts despite new projections that trade tariffs will push consumer prices higher and spark inflationary pressures. Like at any point in the last several years, inflation always seems to be looming around the next corner. Yet it’s not and the Fed can’t figure out why. While the Fed watches and waits, unsure of their next move, the futures market is busy pricing in the possibility of three rate cuts by the end of next year (see chart below.) For those paying attention to price action rather than talking points, the message couldn’t be clearer: the threat of an intensifying global economic slowdown is a much bigger problem than any inflationary uptick.
The short term rate complex is probably the least speculative of any financial market. It’s the quiet man of markets, often dull and boring and largely overshadowed by the latest IPO or equities in general. But its message should never be ignored. Forward rate expectations are breaking down hard, pricing an aggressive reversal in Fed policy. Something is happening macro-economically, and not in a good way. The risk is that trade uncertainties have disrupted supply chains and capital investment more than we thought. And rather than being a temporary phenomenon, tariff regimes could become the new normal, with longer-term impact.
As I noted in “The Dollar and Deflation” and “Fed Resists Market Push for Rate Cuts” a sharp move up in the dollar is a strong and rising possibility as trade and political tensions consume major export-dependent regions abroad like China, Australia, UK, and Europe. The first line of defense for these countries is to offset the drop in activity by letting their currencies fall. All eyes are on the Chinese yuan in particular. A “source” on Friday claimed that China won’t let the currency weaken below 7.00 to the dollar. (See https://reut.rs/2YxkPp9 .) Believe that if you want to but central banks have a history of saying they won’t devalue their currencies, right up until the point that they do. I saw careers ruined in 1994 when Banxico (the Mexican central bank) devalued the peso just hours after insisting to the Street that they wouldn’t.
The rate market is sensing a dollar groundswell. Another leg up in the USD would be deflationary as well as destructive to dollar borrowers abroad. It’s hard to overstate the strength of this message. The dollar-inspired equity selloff of late 2018 might have been the warm-up act for what’s to come in 2019. The Fed and investors alike ignore this scenario at their peril because if this is how it plays out, inflation will be the least of their problems. Be long the dollar and bonds, preferably 2-3-year treasuries.
Amid the back-and-forth of retaliatory trade tariffs between the U.S. and China are some important tells in price action that indicate the situation has moved beyond bluster and snark into a more protracted standoff with negative implications for global growth. Any inclination to think that this too will soon blow over, like previous disputes in the negotiating process, should be checked against the breakdown in commodity prices and treasury bond yields as well as macroeconomic risk benchmarks like the Australian dollar and the Chinese yuan. We warned about this possibility one month ago in What’s wrong with this picture. Both currencies are now perched on a cliff edge (see chart below.) As a proxy for the general global condition, the Aussie dollar’s plight is particularly concerning.
China and the U.S. appear squaring off for a harder fight. Trump clearly sees toughness on trade to be a winning issue for his 2020 election campaign. With an increasingly dovish Fed as his insurance policy against harm to the economy or equity markets, previous assumptions that the president had been bluffing a weak hand or was too eager to cut a deal with the Chinese are proving wrong.
Trump’s aggressive posture is backing Chinese leadership into a corner. One reason blamed for the collapse in talks late last week was China’s demand that the text of any agreement is “balanced,” reflecting respect for its sovereign “dignity.” (https://reut.rs/2JgYqZF ) Those are loaded terms that mean different things to different people. But the need for saving face in many cultures can’t be overstated and the insertion of feelings into the equation now makes any potential deal significantly more difficult to achieve. Investors are right to worry that this sharp-elbows approach on trade by the U.S. will also draw similar reactions when it comes time to negotiate with the Japanese or the Europeans.
Markets are on the edge of a paradigm shift. The FX, commodity, and bond sectors have been telling us for some time that the threat to global growth from disruptions in supply chains and to fixed investments due to changing terms on trade are more pervasive and may be longer lasting than many forecasts currently assume. Volatility is waking up as doubts emerge over central bankers’ ability to counter these headwinds with traditional monetary policy. It’s a massive red flag and a sign that risk may be underpriced. Despite that, the temptation to buy weakness in this ten-year-old equity bull market is both instinctive and strong. But if FX (especially AUD and/or CNH) starts to break lower from here, this time will almost certainly be different.
Friday’s better than expected number for first quarter GDP may be dominating the headlines but it’s the report on Personal Consumption Expenditures that is driving the market reaction. Prices paid by consumers for goods and services, excluding volatile food and energy components, fell sharply in the first three months of the year, extending a decline that began at this time last year (see chart below.) The big drop in US bond yields on the week despite otherwise good news for new home sales, durable goods orders and growth, in general, is a sign that global deflationary forces are gaining an upper hand.
It wasn’t supposed to be this way. In theory, robust growth, rising wages, and full employment create greater aggregate demand that leads to higher prices and higher inflation. Ever since the Fed began raising rates in 2015, tighter monetary policy has been predicated on this basic economic assumption.
The disconnect isn’t limited to the US. Some foreign central banks are beginning to panic as inflation fails to respond to years of stimulative policy. This past week Japan and Sweden joined a growing list of countries putting off any chance of rate hikes in 2019. See here: https://reut.rs/2GI0gjI and https://reut.rs/2IUj6pv . The problem is that like Europe and Switzerland, they too have already imposed negative interest rates and are running out of options to kickstart growth.
Credit to the Fed for pursuing a course of policy normalization over the past few years. They planned ahead. Part of the rationale for raising rates was to make room for rate cuts in the event of a slowdown. While this gives the US a distinct economic advantage on the world stage it doesn’t necessarily mean it will produce a happy ending.
As I mentioned in (See “Good news, bad news“) the downside in this scenario of divergent global growth is that it will drive the dollar higher against the world’s other currencies. In fact, it has already begun. While the equity markets are still celebrating a good Q1 earnings season, the risk going forward now shifts to the negative impact a stronger dollar will have on the bottom line as it makes American exports less competitive. It also starts to turn the screws on entities that leveraged cheap dollars at low rates during a decade of Fed largess. In my opinion, the aggregate short exposure to the USD is grossly underestimated.
The most efficient way to express the view of intensifying deflationary pressure is to own both the dollar and treasuries. The 2-year sector is especially attractive as a play on possible rate cuts and as the flattening trend in the yield curve of the last couple of years begins to reverse (see chart below).
In 2019 the major central banks have been focused on reflating markets by either pausing or reversing plans for policy normalization (higher rates) that hit many markets hard in 2018. Despite ongoing fears of slowing global growth, equities and commodities have so far responded positively to the prospect of easier rates and more plentiful liquidity.
But the one thing that could ruin the party is the strength of the dollar. In my opinion the rising USD was an underappreciated factor that squeezed many regions hard last year, especially emerging economies with current account deficits. Many of these entities had borrowed heavily cheap dollars at low rates under the Fed’s QE program after the 2008 recession, leaving their fiscal position vulnerable as the dollar rose. Not only does it make debt repayment and refinancing more expensive, it also tends to pressure commodity prices that these countries often rely on for exports, creating an unenviable situation where the things they are short (dollar debt) go up and the things they are long (raw materials) go down. And as 2018 proved, because global markets are more interconnected than ever, it wasn’t long before problems in the emerging markets became a problem for the developed markets.
Normally, you would expect that the dovish shift at the Fed this year would undermine the dollar. I certainly did. As it became more apparent that the highs were in for interest rates in early Q4 last year, I assumed the same for the dollar. It was a perfectly logical conclusion given that major currencies often track the path of underlying interest rates. Wrong. Except for a few shallow dips, the dollar has been remarkably resilient. It even shrugged off the appointments of inflation doves Steve Moore and Herman Caine. In the currency world it remains the best of a bad lot and the safety and liquidity it offers in uncertain times can’t be matched. Being short hasn’t cost much money so far but the longer it remains here at the top of its range, the probability grows that the next move is higher.
The chart of the dollar index (DXY) is potentially very bullish, and a break above 97.75 would signal the beginning of a (perhaps significant) leg up. This would unleash a deflationary impulse, and much like in 2018 leave stocks and commodities vulnerable. The world needs a weaker dollar to keep the 2019 bull reflation trade going. But it may not get it.
Here in Washington, DC, packing the courts is a charge frequently used by both parties to accuse political opponents of trying to influence judicial outcomes by getting their guys of similar ideology seated on the bench. This comes to mind with news that President Trump intends to elevate Herman Caine to join recently-appointed Steve Moore to the Fed https://on.wsj.com/2CX3vBv. By putting forward two notable inflation doves (and political allies,) it’s clear that the President is trying to tip the balance of power on the board to favor a more market-friendly composition. Wasting no time, Moore called on the Fed to begin cutting rates immediately https://cnb.cx/2uvSWRm.
Late last year as global growth slowed and equity markets stumbled badly the president made no secret of his feelings toward the Fed, blaming them for having no ‘feel’ for market conditions as they continued to methodically raise rates https://reut.rs/2ONDd9M . The data since then suggests Trump was right. As the stimulative impact of last year’s tax cuts fades and signs of weakness in the economy intensify, Trump is leaving nothing to chance. For a president that often references the Dow as a benchmark for economic policy success, he intends for the Fed to be his electoral insurance policy.
Until recently the Fed had been generally dismissive of the trend toward a flatter yield curve and the negative implications it carried for the trajectory of inflation and the economy, choosing instead to trust that the rising tide of a robust labor market would push prices higher and continue to justify the steady march toward policy normalization from post-recession extremes.
But this week a red flag appeared in the market that will be hard for the board to ignore. The benchmark 2yr treasury yield fell below the Fed’s main policy rate, a sure sign that despite official forecasts the peak of the current rate path is rapidly approaching, if not having already passed. Economic cycles have unknowable but finite lifespans. Even though the current expansion that began in June 2009 is only a few months from being the longest in history, the inversion in rates suggests the possibility that the old record may be safe.
At the upcoming March 19-20 policy meeting the Fed will be forced to address the large and growing gap between their own projections and the outcome being embraced by the short-term rate complex. The Summary of Economic Projections (SEP) last updated in December foresaw two rate hikes in 2019 and one more in 2020, ultimately putting the current Fed Funds rate of 2.40% at around 3.125%. The problem for chairman Powell is that over that same time period the market is not only not pricing in rate hikes but an easing instead, discounting a lower year-end 2020 overnight rate of 2.15%.
Having learned from the experience of the bond market massacre in 1994 triggered by a surprise hike in rates the Fed has not since tightened unless the futures market has priced in at least a 70% chance of it happening https://bit.ly/1Khc3xm. Seeing that market-based odds for any further rate hikes over the next couple of years is essentially zero the economy would have to rebound sharply to put any further tightening into play. It’s not impossible but a highly unlikely scenario at this late stage in the expansion.
Reconciling the difference with the marketplace is a tricky proposition for the Fed. The market is clearly pushing them to ease but without more evidence of economic weakness they are reluctant to abruptly reverse course and jeopardize their credibility by perhaps being too reactive to the normal ups and downs in growth. In addition to that they risk being seen under the thumb of the president Trump, who late last year criticized current policy and chastised them for not having a good feel for the economy and markets https://nyti.ms/2T936Bh.
The lesson of 2018 is that in an increasingly inter-connected global economy, policies of the major central banks can diverge for only so long before something snaps, and the convulsions in the equity markets late in the year were a sign that a breaking point had been reached. Rising rates and an accompanying strong dollar exposed many corporate and sovereign entities to the perils of having leveraged themselves with cheap USD funding under quantitative easing.
Ongoing geopolitical and trade uncertainties now require the Fed to be a force for stability, not a source of volatility. A backstop for global economic weakness. While the board won’t fully embrace easier policy next week they will take the market’s lead and begin making baby steps in that direction. Investors should take this as further evidence that a top in rates and the dollar is in place and that any talk of higher rates is just that…..talk.