Reading the tea leaves from the central banks

Weekly Market Compass: What did we learn last week from the central banks, trade talks and the markets?

Aug 28, 2018 | Kristina Hooper

Last week gave us a look into the thoughts of the US Federal Reserve (Fed) as Fed Chair Jay Powell gave a widely anticipated speech, and the Federal Open Market Committee (FOMC) released the minutes from its most recent meeting. Some of the messages were clear, while other statements required observers to read between the lines. Below are five key takeaways from last week, and five items I’m watching going forward:

1) FOMC indicates a September rate hike may be a done deal. According to the FOMC meeting minutes: “Many participants suggested that if incoming data continued to support their current economic outlook, it would likely soon be appropriate to take another step in removing policy accommodation.” In other words, a rate hike in September is very likely — barring any unforeseen circumstances. However, it’s important to note that those minutes also indicate continued concern about the impact of trade wars on the economy: “Wide-ranging tariff increases would also reduce the purchasing power of US households.” It’s become enough of a concern that some FOMC participants are already worried about how the Fed would respond, stating that “in the event of a major escalation in trade disputes, the complex nature of trade issues, including the entire range of their effects on output and inflation” presents “a challenge in determining the appropriate monetary policy response.”

2) Powell discusses the risks of moving too quickly or too slowly. In his speech at the Kansas City Fed’s annual Jackson Hole symposium, Powell reassured listeners that the Fed will continue to navigate between the two major risks facing the economy: 1) moving too quickly and curtailing the current economic expansion and 2) moving too slowly and causing the economy to overheat, which could be destabilizing. Powell noted that the economy has continued to strengthen, but he sees no risk of overheating. He also promised gradual rate hikes going forward.

In addition, Powell extolled the virtues of a “risk management approach” for a new type of economic growth — something he said began with Alan Greenspan in the mid 1990s. As he explained, “in the run-up to the past two recessions, destabilizing excesses appeared mainly in financial markets rather than in inflation. Thus, risk management suggests looking beyond inflation for signs of excesses.” In particular, he praised Greenspan’s decision to hold off on raising rates in the late 1990s because inflation was not rising. He suggested Greenspan was prescient in believing there could be a new paradigm where the economy continues to grow without a significant rise in inflation.

I have been wondering all weekend about what message Powell was intending to send in this portion of his speech. Yes, he is suggesting that the Fed can’t be guided by old rules and that it has to be open to new paradigms. However, I can’t ignore the similarities between the economy of the late 1990s and today — significant growth with low inflation. And I have come to the conclusion that he may be suggesting very few rate hikes in the coming year or two if economic data doesn’t change significantly. While the Fed is an independent body, perhaps this was a nod to US President Donald Trump, who has been publicly criticizing the Fed for raising rates.

Interestingly, this “greater gradualism” approach was also advocated by another central banker who has recently shown a propensity for rate hikes — Stephen Poloz of the Bank of Canada. In his comments at Jackson Hole, Poloz also struck a reassuring tone as he argued for caution in hiking interest rates — and even discussed the possibility that the new economy is tamping down inflationary pressures, echoing Powell’s comments.

3) In Europe, the central bank remains cautious. Minutes released from the most recent European Central Bank (ECB) meeting indicate that monetary policy normalization may be slow and cautious. The minutes show the ECB is committed to not raising rates until next summer, if not later. In addition, the minutes show that the end of tapering — which is expected at the end of this year — is contingent on economic data in the next several months.

But perhaps the most important development for the eurozone last week had nothing to do with the ECB meeting minutes; it is rumored that Germany will not nominate Bundesbank Governor Jens Weidmann, widely regarded as a monetary hawk, to replace Mario Draghi next fall as ECB president. This means monetary policy could remain more accommodative for longer — which could be a powerful countervailing force to a Fed that continues to tighten at a quick pace, and could also spell weakness for the euro versus the US dollar.

4) Sino-American trade talks fizzled. Despite high hopes, US-China trade talks ended last week with no real progress. It appeared to me that investors were grasping at straws several weeks ago when stocks rose on news of these talks; now it seems clear how misplaced their optimism was. These lower-level meetings yielded little in the way of results, and they ironically concluded just as more US tariffs on Chinese goods were going into effect.

Also, it’s important to note that last week the Chinese government announced the start of a major infrastructure spending initiative. Clearly, China is ramping up its stimulative tools and working to bolster its economy as the tariff situation worsens. Investors should read between the lines: In my view, trade tensions will worsen before they get better.

5) Stocks set a record, but bonds indicate caution. As I expected, the US stock market moved higher and broke a record on Wednesday when the current bull market broke the record for the longest bull market in decades. Then on Friday, both the S&P 500 Index and the NASDAQ Composite Index closed at all-time highs.

However, against this elation, the yield on the 10-year US Treasury moved lower — to 2.81%.1 That resulted in the spread between the 2-year and the 10-year Treasury yield falling to 19 basis points as of Friday.1 This is the lowest level we’ve seen in more than a decade and, of course, the spread between the 2-year and the 10-year means we are coming dangerously close to an inverted yield curve. In my view, we can’t let the euphoria over stocks overshadow what the bond market may be telling us, especially given that bonds have typically been a far better indicator of rational fear than stocks.

What to watch going forward:

1) NAFTA. The US and Mexico announced this morning (Aug. 27) that they have reached a preliminary agreement on the North American Free Trade Agreement (NAFTA), and stocks are celebrating. The two countries have been talking to each other in recent weeks, and the next step was to re-engage Canada in the negotiations so that the three countries could have a signed agreement by December, which I thought was unlikely. However, Trump just surprised markets by announcing that he would be dissolving NAFTA and just moving forward with a bilateral agreement with Mexico (with Canada’s involvement an open question). I believe the dissolution of NAFTA is more than just semantics, and in my view it will only aggravate an already worsening trade situation.

2) Brexit. The Brexit situation is getting worse, with a growing likelihood that the scheduled completion date of March 2019 may arrive with no deal in place. The coming weeks will be critical, so we will need to follow this closely.

3) Italy. Italy needs to agree on a budget next month in order to send it to the EU on schedule. This was already going to be a difficult task given the conflicting demands of the European Union — which requires fiscal discipline in its members — and the needs of the country, especially in the wake of a deadly bridge collapse that underscored the need for far greater infrastructure spending. However, Italy just announced it will not adhere to the EU’s budget rules, setting the stage for more conflict between Italy and the EU in coming weeks.

4) Australia. Disruption has spread to Australia with the ouster of Prime Minister Malcolm Turnbull last week. However, while populism caused the toppling of Turnbull, the populist candidate Peter Dutton was not successful in his bid to replace Turnbull. The reality, though, is that despite solid economic growth, Australians feel economically vulnerable after years of taking on household debt and witnessing stagnant wage growth. So while there is not a populist in the PM seat in Canberra, populism is alive and well in Australia and could rear its head again. The coming weeks will be critical as new Prime Minster Scott Morrison forms his cabinet, sets his agenda — and appears to be facing an election in Turnbull’s district in order to secure a majority in parliament.

5) Elections. Mid-term elections are coming up in the US in September, and we continue to receive questions on this topic. Japanese elections will be held in September as well. I will be covering both elections in more detail in the coming weeks.

1 Source: Bloomberg, L.P., as of Aug. 24, 2018

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The opinions referenced above are those of Kristina Hooper as of August 27, 2018.

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