The Fed just blinked.

Thursday, 29th November 2018 07:37 - by Shant

Last week we highlighted the growing belief that the Fed may have to start reining in some of their rhetoric on tightening, having seen the stock markets react to the sharp push higher in Treasury yields in October.  Since then, there has been a mix of data which on balance continues to show economic strength in the US, though there are clear signs that the pace of growth is slowing.  Given economic prowess has been unrivaled across the globe, it is no wonder then that the US Dollar has also seen rampant gains, adding to tightening financial conditions.  

It is, therefore, reasonable to assume, that the FOMC will monitor developments in the economy and reassess the level of monetary appropriate to maintain economic momentum.  Speaking at the Economic Club in NY this evening, Powell suggested that rates are now just below the neutral rate. Despite the actual level being a bone of contention - among Fed members no less - the fact that his wording suggests we are closer to it than previously conceived, has underlined the notion that 3 to 4 hikes next year is by no means a given.  In a climate when global dynamics can and do change as quickly as they do - both politically and economically - it never ceases to amaze when the market is so forthright in pricing in best and worse case scenarios, or extremes as it were. 

Even so, the largest impact of his comments is seemingly on the US Dollar itself, which has somewhat overstretched valuations against its key counterparts. This has naturally had an impact on exports. When you look at the latest trade deficit, which is widening again, we can see that the stronger Dollar allied with secondary effects of the trade tariffs is and should also be a cause for concern.

The longer end of the Treasury curve is still relatively unchanged as the benchmark 10yr Note continues to hold above the 3.00% mark. In this instance, the positive stock market reaction may be a little premature, if we do indeed see the impact of monetary policy and the fading fiscal stimulus have a more pronounced effect on US business activity.  Political decisions have led to strains on global trade which may eventually come back to haunt the US administration, but for now, Powell maintains a positive outlook on the economy.  It is hard not to, when unemployment is below 4.0%, though I am somewhat underwhelmed with the comparative wage growth.  Inflation then becomes a negative driver, which in turn will later have an impact on consumption - a major driver on US growth.  

So once again, we may have seen a relief rally in stocks (Wednesday evening), but Wall Street is not out of the woods just yet.  Certainly, from a short-term interest rates perspective, stocks have been given some breathing space, but note the Fed is also slowly shrinking the balance sheet and with nearly a year into the painfully slow process, the cheap money is drying up from the other end of the policy spectrum.  This also has the effect of underpinning the US Dollar, so the balancing act is ever more precarious for the Fed at the present time.  This naturally leads us to assume that a shallower rate path lies ahead of us. I was never on board with the 4-5 hikes scenario beyond 2018, as I have alluded to above.  The global economy is a little more fragile than some would have you believe.  

While there is 'short-term' value to be had in the aftermath of a strong correction in the US markets, we envisage any current buying opportunity is to be viewed on a 'limited timescale'.  Amid the backdrop of quantitative tightening as I have already mentioned, the onus will revert back to growth (after many years) and genuine growth at that.  We all knew the distortions that QE of the past has permeated had to come to an end at some point.  Not that that point is imminent, but it is worth considering at the present time. 

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.