It looks like the Fed is set to blink.

Thursday, 22nd November 2018 07:22 - by Shant

Over the short week so far, it has been a destabilising time for the US stock markets.  Finally succumbing to the fact that cheap money is running out and that earnings per share will have to be justified on sustainable growth, a series of heavy losses on the major indices have come as little surprise to many. 

Not only are the Fed raising rates, but we are also in a period of quantitative tightening, which serves as a double whammy for stocks - globally.  For the US, the higher Dollar is adding to tighter financial conditions, with the US trade deficit widening to boot.  

More recently, reports have been circulating that the Fed is now likely to pause in their tightening cycle beyond the 25bp move expected at the Dec FOMC.  Whether the Fed is justified in doing this at this stage is hard to determine, but it is all about getting to the neutral rate (r*), where we can achieve economic equilibrium, which is tough at the best of time, let alone after years of distortion from QE.  Quite how Japan is going to recalibrate its monetary policy after its continuing program of asset purchases is an even more daunting prospect, and will no doubt add to global volatility when they choose to change tack.  Having watched the impact on US stocks from rising Treasury yields, it is not going to be pretty, especially with the level of divestment out of Japan, and largely into the US.

For now, US equities may get some relief if the Fed guide the market towards a more flexible approach to their rate profile for 2019.  Consequently, the market is warming towards 2-3 hike next year against a potential of 3 or 4 hikes.  My personal view is that the Fed may only feel comfortable in raising twice next year.  While chairman Powell is keen to stress that the markets are less of a concern - certainly less so than the real economy - the confidence factor will be compelling if all hell breaks loose over the coming year.  It is not as if the risks are completely unknown.  The US continues to press China to change its unfair practices, and this has already caused significant ripples elsewhere in the world, with major exporting regions such as Europe feeling the heat especially.  Geopolitical risks including North Korea and more recently Saudi Arabia are also cause for investors to switch funds into safe havens. 

Price action this week has shown a flight to safety with Treasuries sought, and as we have seen this, this week, the US 10yr Note was pulled back to close to 3.01-2%.  This narrowed the 2s10s spread towards 20bps again, before widening out to the more familiar 25bp level.  At this stage, worries over a US recession would probably be seen as a little excessive, though one would expect an economic downturn to some degree and stock markets cannot and will not ignore this with Fed Funds pushed higher.  

Thankfully - for the Fed - inflation is relatively well contained for now, though producer prices have risen considerably and everyone will be pointing to the US trade policy to blame for that.  

For the man on the street - or block (in the US), the news that house prices are falling will bring back worrying memories of 2007 and 2008.  On the global scale, US household debt is not as high as in other major developed economies - Australia, Canada, the Netherlands among them - but in this instance, leverage has to be factored in.  When combined with fears over the levels of student loans as well auto financing (which has hit auto sales), we have the makings of another debt dilemma in the US which adds another serious question mark over the valuation of US companies based on their outlook on consumption and sales - especially those less internationally diverse.  

If a less hawkish Fed can rein in some of the Dollar strength seen over the past 6 months, this would add some further relief to the US stock indices in the exporter sectors, but as it currently stands, rates, exchange rates, and domestic stocks have all pushed up in tandem and that never ends well.  Stocks have blinked - now it's likely time for the Fed to do the same. 

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.