Fed policy turns flexible - no one should be surprised

Monday, 7th January 2019 12:24 - by Shant

While the trading year starts in earnest from today, events at the end of last week gave risk assets reason for some near term cheer.  We saw the employment data showing signs that tight labour markets may indeed translate into stronger wage growth, which at the very least, could give the US consumer and economy some added legs.  Naturally, we will need to see some continuance in the data metrics, and in the new year, the earnings components will - or should be - of greater factual interest give wage increases are usually agreed (or not) at the start of the year.  This could be the time we see pay increases showing up to a larger degree. If not, this could suggest tighter margins are holding back remuneration incentives and may be cause for concern further down the road.  

Of greater significance over the shorter term however were comments from Fed chair Powell late Friday, who was taking part in a Q&A session with ex-chairs Yellen and Bernanke.  Key within his comments were that Fed policy will be more flexible in light of the events seen in the markets, where the Wall St indices have suffered some of the largest monthly losses not seen since the GFC.  Jerome Powell admitted that policy can be shifted in line with economic developments, consistently highlighting data dependency in a bid to wean markets off forward guidance.  In macro world, this has had a damaging effect - if not overtly apparent at times - in that it has pushed implied rates to extremes as we saw last year.  Not for the first time have I mentioned the impact on risk assets when the benchmark 10yr Treasury Note hit 3.25% (and 30yr 3.45%).  We saw a sharply negative impact on global indices at the time and in the aftermath, the realisation of balance sheet contraction coupled with the insistence to raise rates in the Dec meeting sealed the fate of equities going into year end.  

Well now the Fed is indeed listening to the markets and it looks pretty clear that financial conditions have reached their zenith in terms of comfort for risk asset valuations.  Looking at the economic data, there have been clear signs that growth momentum has been slowing.  Last week's manufacturing ISM was a clear indicator of this, though by no means do we consider this a reason for panic.  Patience yes. As such, the Fed has every reason to stand pat on rates for now, as perhaps they should have done in Dec.  That is history now and markets have priced out the Fed hike which was anticipated in the March meeting.  At this stage, it looks more than likely that the FOMC will keep rates unchanged into mid-year at the very least, though ruling out further tightening seems to be a step too far when considering some of the positive lagging data such as the jobs report mentioned above.  

All this points to a relief rally in stocks for now, and judging by the reaction on Friday, the data-Fed cocktail was enough to prompt an 84pt rally in the S&P 500 while the Dow posted gains close to 750pts.  The NASDAQ responded in kind with 275pts added back onto the index and the reverberations fed through global markets with Asian stocks quick to follow suit with the Nikkei up nearly 2.5% overnight.  

Europe has been a little more reluctant to follow the lead, though with Eurozone data failing to inspire in any way, shape or form, we would have expected a degree of underperformance.  The Brexit outlook also remains no clearer as the withdrawal date draws nearer, though the UK parliament is back this week to take up the debate for the meaningful vote next Tuesday. As we have seen reflected in the Euro, alongside Sterling, the prospect of a no deal outcome has heightened given the lack of support for Theresa May's deal and the disruptive impact is influencing sentiment on both sides of 'the Pond'. Any easing in trade tensions through a pact between the US and China would be positive for stocks globally, but we would argue that Europe would then offer the better opportunities given the concentration of export-led industry in the region.  

For now, US stocks which have underperformed on their respective debt to equity ratios look to be the best (and obvious) place to express one's short-term view on Fed monetary 'leeway'.  

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.