Macro Wrap-Up

The First Cut Is the Deepest

Topics - Macroeconomics

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The First Cut Is the Deepest

Happy New Year! Anyone who took the holidays off will notice that the year-to-date returns of the S&P 500 have suddenly improved. Particularly observant returning vacationers may also notice that U.S. money market curves have changed fairly significantly since Thanksgiving. 1 1 Close Some people take long vacations.  Now, Fed Funds futures are pricing very little in the way of rate hikes in the first half of 2019. These same futures are also pricing almost a full cut by the end of next year. This pricing comes after the Fed hiked rates four times last year, and many economists are predicting more hikes. While some in the Fed may think we are in the middle of a hiking cycle, money markets are saying it’s pretty much over.

As we discussed in December, there has been a shift in Fed rhetoric, which has clearly affected pricing. Several regional Fed Presidents have pointed to weakness in the economy and called for caution. 2 2 Close Bloomberg: “More Fed Officials Pile on Bandwagon Favoring Rate-Hike Pause,” 1/9/19.  Chair Powell himself has adopted more of a wait-and-see approach. His comments indicate that a March hike, which had been widely expected, is now far less likely. 3 3 Close New York Times: “Jerome Powell Says Fed Will Be Patient. Then He Says it Again,” 1/10/19.  But markets are taking it one step further by pricing a full end to the cycle. Market participants may be looking at history, where they see that the Fed can quickly turn from hikes to cuts when the economy slows. For example, in late 2000 many folks expected the Fed to continue tightening, only to be surprised by an inter-meeting 50bp cut in January of 2001 followed by aggressive rate reductions throughout the year. 4 4 Close Federal Reserve: “Open Markets Operations Archive.”  In that case, the Fed saw weak data as a warning that a recession was imminent and felt a quick change was necessary. 

Forecasters are calling for continued growth in the U.S., but fears of a recession have been lurking in the background like a photobomber offering bottles of Fiji water. There is strong evidence that the U.S. is slowing after growing rapidly in 2018. Many companies have turned cautious on future earnings, and there are few signs that investment is improving. 5 5 Close Bloomberg: “Market Earnings Angst Goes Beyond Apple With Outlooks Darkening,” 1/3/19.  Housing activity has been challenged by higher rates. The Institute of Supply Management Manufacturing PMI numbers, which had been among the strongest data points, fell in December. 6 6 Close The ISM Manufacturing PMI for December 2018 fell from 59.3 to 54.1, well below Bloomberg median economist forecasts of 57.5. Source: Bloomberg.

Recessions are very difficult to predict, and while the old joke goes that the stock market has predicted nine of the last five recessions, economists may have predicted five of the past five. Just not at the times when they happened. 7 7 Close Of course, some forecasters take the approach of always predicting recessions. That is the only way to be sure not to miss any.  It often feels like we are wandering around the woods blindfolded, with some supernatural monster about to pounce on the economy. 8 8 Close There was a similar movie where a family was running away and couldn’t make a sound. That movie is not as good of an analogy to market investors who seem to have great difficulty keeping their opinions quiet.  Still, if we do examine the economic indicators, the slowdown does not point to an obvious conclusion that a recession is coming. Employment is still very strong, and while that is often considered a lagging indicator, spending numbers point to healthy consumption. Financial conditions are not showing signs of excessive tightness.

The markets aren’t really pricing a full recession anyway. A recession would likely lead to a large reduction in policy rates, as opposed to the very modest amount currently priced. It may be that markets haven’t fully given up on hikes. Still, the outcome most consistent with current money market pricing is an end to the hiking cycle without a recession. This is the mythical soft landing. 9 9 Close They are rare. The last real soft landing in the U.S. was probably after the aggressive 1994 rate hikes. Sure you could say that there was no recession after the single hike in 1997, but one hike does not make a cycle. While such an outcome is rare, it may be more likely this time because of the lack of price pressure. If we continue to see moderate inflation, the Fed may not feel the need to raise rates even if the economy continues to grow. If inflation starts to fall, the Fed may have room for limited rate cuts.

A soft landing scenario of lower rates without recession would be ideal for stocks. Recent returns in equities do not show such optimism. This brings us to a more cynical view of market pricing. The markets may be pricing the end to the Fed cycle simply because stocks have been down. While Chair Powell has implied that the Fed is going to be less reactive to equity price moves than it has been in the past, market participants seem not to believe him. It is also possible that investors think the stock market is a good predictor of economic risk. This view will be tested if equities recover. Other cynics might argue that the Fed is merely succumbing to political pressure. This also contradicts Powell’s repeated denials. Such a loss of central bank independence would be good for short rates but potentially more problematic for longer term bonds and equities.

Because the markets are made up of many participants with differing views, there really isn’t a single correct interpretation of market pricing. The recent shift in front-end rates does seem to tell us that that the psychology of money market investors as whole has shifted. For much of the 80s, 90s and 2000s, money market investors and hedgers lived in constant fear of higher rates and priced a fair premium for them. Now after being burned by several cycles of rate cuts, markets are much more sensitive to perceived recession risk. This change in sentiment is important to understand because, in some ways, it means that risk premia in the market has changed. It means that investors looking to interpret what implied Fed pricing means for other markets should be cautious about extrapolating from past experiences. It also means that the market participants should be wary of alarming conclusions based on current Fed Funds pricing. 10 10 Close Of course, Larry Kudlow has said that there are no signs of recession, so that should scare investors.  The current Fed Funds market is not precluding any future hikes or growth in the economy in 2019.


What We Are Watching


 U.K. Parliamentary Vote on Withdrawal Agreement (Tuesday) In November, Prime Minister Theresa May reached a deal with the European Council on a Withdrawal Agreement (WA) outlining how the U.K. would leave the European Union in an orderly fashion. 11 11 Close For all 585 pages of the Withdrawal Agreement, see – European Commission: “Draft Agreement on the withdrawal of the United Kingdom of Great Britain and Northern Ireland from the European Union and the European Atomic Energy Community, as agreed at negotiators' level on 14 November 2018.” 11/14/18.  However, the WA has run into significant opposition in the U.K. parliament, which must approve the deal before it can be put into effect. With time running out before the scheduled Brexit date of March 29, May has attempted to rally popular support for the WA. However, it still appears likely that parliament will vote down the agreement when given the chance this week. 12 12 Close The Telegraph: “When is the Brexit ‘meaningful vote’ in Parliament, and what will happen if Theresa May’s deal is rejected?” 1/11/19.  This could open up a period of heightened uncertainty, particularly if an emphatic rejection of the WA causes Prime Minister May to resign or lose a vote of no confidence. If May remains in office, she could use the impending March 29 deadline to pressure parliament into falling in line at the last minute. Failure to reach an agreement (or obtain an extension) by the end of March would result in a disorderly “No Deal” Brexit, which might have a significant negative impact on the U.K. economy.


U.S. Retail Sales (scheduled for Wednesday, but unlikely to be released on time) U.S. consumer spending growth ticked up in 2018 13 13 Close The average YoY retail sales growth for year-to-date through November in 2018 moved up to 5.2% from 4.7% in 2017. Source: U.S. Census Bureau.  and its resilience remains a key reason for positive GDP growth forecasts in 2019. A strong labor market, rising household incomes, and falling energy prices have all been supportive of household spending. However, the sharp deterioration in risk appetite at the end of last year, lingering concerns about trade wars and, more recently, a government shutdown could generate headwinds for consumption moving forward. In fact, the government shutdown makes it unlikely that the retail sales report for December 14 14 Close The busiest month of the year for retail activity.  will be released on schedule, as a number of official statistical releases have been delayed. Shutdown-related disruptions to economic data collection may force investors and policymakers to place greater emphasis on less prominent releases, such as the Beige Book and Industrial Production reports published by the Fed (scheduled for Wednesday and Friday respectively).


Canada CPI (Friday) Inflation spent most of 2018 above the Bank of Canada’s 2% target before slowing sharply into the end of last year. Much of this volatility can be attributed to energy prices, as the Bank of Canada’s “core” measures of inflation have been more stable around 2%. Oil production and its related businesses are a meaningful part of the Canadian economy, suggesting that energy price declines will likely impact growth as well as inflation. Although Canada’s unemployment rate has fallen to its lowest level in several decades, lower headline inflation, slowing growth and increasing external concerns have led the Bank of Canada to pivot to a less hawkish stance. If CPI data continues to decelerate, the central bank could decide that no further rate hikes are warranted this year, weighing on the Canadian dollar and supporting domestic fixed income.

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