Summary: The market has read the Fed chairman's latest remarks as dovish but the difference between this and earlier statements is marginal. Meanwhile, investors are eager to see whether Trump can master the art of making a deal with Xi.
Since the now-famous speech by Fed chair Jay Powell in early October saying that Fed rates were “a long way from neutral”, we have seen a variety of backtracking attempts by several of the bank's officials with various members outlining a more nuanced approach to tightening.
Overnight , Powell notably observed that rates "remain just below the broad range of estimates of the level that would be neutral for the economy."
On balance this is marginally dovish, but no more than that. With the estimation that the neutral rate lies between 2.5% and 3.5% the bottom of the range is only one hike away (therefore we are “just below”), but we are five hikes away from the top of the range (“a long way”). Powell may be leaning on the dovish side in the way he delivered the statement to the market but depending which way you spin it the difference is marginal, there are plenty of ways to skin a cat.
We continue to see the December hike as dovish, with an expectation the 2019 dot plot will be revised downwards as the US economy is beginning to roll over and the Fed’s ability to continue tightening will disappear soon.
As always, the Fed ultimately will do what the data tell them to do, and we think whilst the absolute level of rates remains low by historical comparison, the dramatic pace of tightening will begin to show in the data. In rate of change terms this tightening cycle is actually one of the largest we have seen.
Recent inflation readings have either missed or met expectations. Economic growth will decelerate in most G20 economies in 2019. The headline CPI now has an increased sensitivity to goods and commodities prices and the recent 33% fall in oil prices will weigh on the headline inflation rate globally.
Given that energy has a weight of 8.1% in US CPI, a 10% YoY drop in the oil price reduces the headline CPI by around 0.2%. On average CPI surpasses PCE inflation by around 0.4%, so downside risks to the Fed’s inflation forecast for next year exist if current prices for oil hold. Already the collapse is weighing on inflation expectations with the US 10-year breakeven inflation rate declining 20bps to 1.95%. Along with the oil price decline, structural deflationary shifts outweigh the wage/price inflation linkage and are more powerful than the downdraft in unemployment.
On that basis we look for Treasuries to become a buy and the dollar to reverse its course, however, outright positioning may be premature at this point. We look for a move lower in yields after the Fed’s December meeting, this view can be expressed through call option strategies. For the dollar to reverse its upward trajectory we await 1H19 when we believe the Fed will pause and the relative growth leadership of the US economy will have faded.
'The dinner of the decade'
The next catalyst for markets will be the G20 meeting between Trump and Xi this weekend. We believe risk assets will tactically trade in the green following a tariff ceasefire, negating the January tariff hikes and further impending tariffs. The Aussie dollar as the China risk proxy currency could be the relative winner here.
A tradable risk bounce on a handshake deal at G20 will be unlikely to reverse sentiment structurally as the underlying US/China relationship is still deteriorating. A handshake deal with little meat on the bones won’t do much to help the war of attrition unfolding over technological and economic dominance.
Whilst the meeting is encouraging, there is of course scope for the US trade hawks to push the hardline approach and the meeting could end with no agreement. Whilst we believe the first scenario is more likely, both sides must be considered as even within the Trump administration there is a marked split on the approach to China.
Vice president Pence sits on the side with the hawks and recent comments have been less than reassuring: “The United States, though, will not change course until China changes its ways”… “China has taken advantage of the United States for many years. Those days are over”. It's fair to say there is no hint of compromise from Pence. Across the fence with the trade doves sit White House advisor Larry Kudlow and treasury secretary Mnuchin who are both concerned about the knock on effects in financial markets and the US economy. The good news, according to Kudlow: Trump is “open to a deal”.