Fed Chair Powell plays the Senate with a straight bat

Friday, 20th July 2018 10:46 - by Shant

Many were pointing the Fed chairman's semi-annual testimony as one of the key risk events this week, where addressing members of Congress he faced a range of questions from productivity, to wage growth and distribution, to the yield curve and somewhat predictably the impact of trade tariffs. 

The latter is a hot topic naturally, though quite what questions on his views on the policy directive were supposed to uncover is beyond me I'm afraid.  Economists agree that tariffs will dampen trading conditions the world over and naturally Jerome Powell agreed.  Whether his words and that of many others will influence the president and his administration is another matter, but there will be consequences for the US economy, as Senator Donnelly noted with Indiana Soya Bean farmers, again, to full agreement of the Fed chair.  

Starting off the testimony, the chairman Powell presented the Fed's outlook on the economy which continues to grow at a solid pace and in which employment is expected to fall further.   Q2 is expected to be significantly strong, and as noted in the opening address by the chairman of the Senate Banking Committee, the Atlanta Fed projection for the second quarter lie close to 5.0%.  Even so, the Fed chair maintained that gradual policy tightening will be maintained and as it stands, the market is pricing in another 37-37bps for this year which puts the odds of a fourth hike at a little over 50%.  

While financial conditions remain favourable to growth and inflation, wage growth is still below levels seen before the financial crisis and this really is the only fly in the ointment on an otherwise dream run for the Fed and the US economy.  But is it? 

A common feature in the questioning was that of real earnings and earnings across the labour spectrum.  A number of senators acknowledged that may Americans had not seen material nominal wage increases over and above inflation to reflect the rewards the economy as a whole as benefiting from.  As the Fed chair rightly pointed out, there were and are, only so many tools at the hands of the central bank, namely monetary policy.  Given the Fed have been forced to delay rate hikes for as long as they have, Powell had no hesitation in returning the answer back to Senator Cortez Masto - who argued most vehemently for this - given fiscal policy is the only answer to address inequality of this kind.  

Perhaps more interesting for the market was the question on how the Fed chair viewed the flattening yield curve.  At almost 100bps a year ago, the 2yr vs 10yr spread is now at just 25bps, though the previously widespread perception that this is a prelude to an oncoming recession has faded in recent months.  This is in no small part due to the acceleration in US growth in Q2, and here the Fed chair sought to focus on the long end and where it implies terminal rates rather than what the gradient infers. On this basis, surely the Fed may be tightening a little too fast, and were we to see the curve flattening further still, do we understand that the Fed dot plot is a little firmer than it needs to be?

Either way, the impact on US stocks has been negligible, where equities were anticipated to have lost ground on the steeper rates.  Having covered the impact of QE elsewhere last week, and we point squarely to Japan on this, there are potentially large inflows into US assets which are distorting the familiar narratives and correlations, with the USD/JPY exchange rate defying valuation levels on many time-frames.  

Senators also pointed to the level of share buy-backs, which have been a major contributor to a resilient stock market, more as a criticism of the Fed's leniency towards banks.  The Fed are being accused of effectively looking the other way when it comes to capital adequacy, seen allowing the major banks to return to the days of leveraging on investments.  Congress is naturally sensitive to this given the bail-outs of 2008 are still fresh in the memory, and the rhetoric from certain Senators highlighted the frustration to the level of profits generated and distributed under the context of wage inequality which was a strong undercurrent in the testimony today.

Congress is fully aware of the disparity in what stock markets are supposedly telling us in comparison to the real economy and at some point this disconnect will correct and correct sharply.

The Writer's views are their own, not a representation of London South East's. No advice is inferred or given. If you require financial advice, please seek an Independent Financial Adviser.