In the Aftermath of the Fed
The baton has been dropped. The Federal Reserve was by far the most aggressive major central bank through this past financial epoch (the last decade) to embrace ‘normalization’ of its monetary policy following its extraordinary infusion of support through rate cuts and quantitative easing (QE). Over the past three years, the central bank has raised its benchmark rate range 225 basis points and slowly began to reverse the tide of its enormous balance sheet. As of the conclusion of this past week’s two-day FOMC policy meeting, we have seen the dual efforts to level out extreme accommodation all but abandoned. A more dovish shifted was heavily expected given the statement in January’s meeting, the rhetoric of individual members as well as the state of the global markets and economic forecasts. Yet, what was realized proved more aggressive than the consensus had accounted for. No change to the benchmark rates was fully assumed, but the median forecast among the members accounted for a faster drop than the market likely thought practical. From the 50 bps of tightening projected in the last update in December, the median dropped to no further increases in 2019 and only one hike over the subsequent two years.
The Dollar responded abruptly Wednesday evening with a sharp tumble, but there was notably a lack of follow through where it counted – the DXY Dollar Index wouldn’t go the next step to slip below its 200-day moving average and break a ten-month rising trend channel (a hold that confounded those trading an presumed EURUSD breakout). Why did the Greenback hold – for now – when the move was clearly a dovish shift? Likely because the market is already affording for an even more dovish forecast as Fed Fund futures have set the probability of a 25bps cut from the Fed before the end of the year as high as 45 percent. What’s more, if you intend to trade the Dollar; it is important to recognize that even with a more dovish path ahead, the Dollar and US assets will maintain a hearty advantage over its major counterparts. That would particularly be the case should other groups extend their dovish views to more actively explore deeper trenches of monetary policy.
Looking beyond the Dollar’s take, however, there are far more important considerations for the global financial system and sentiment. The Fed was the pioneer of sorts for massive stimulus programs designed to recharge growth and revive battered markets. It was also the first to start pulling back the extreme safety net when its effectiveness was facing deserved scrutiny by even the most ardent disciple of the complacency-backed risk-on run. In other words, its course change carries significantly more weight than any of its peers. The question ‘why is the Fed easing back and so quickly’ is being posed consistently whereas in the past market participants would have just indulged in the speculative benefits. The overwhelming amount of headline fodder – from trade wars to frequency of volatility in the capital markets – makes for a ready list of considerations. Yet, the group’s own economic forecasts brought the reality home far more forcefully.
Though we have seen numerous economic participants downgrade the growth outlook (economists, investors through markets, the IMF, etc), to see the median GDP forecast in the SEP (Summary of Economic Projections) lowered from 2.3 percent to 2.1 percent for 2019 made the circumstances explicit. We’ve considered multiple times over previous months what happens if the market’s start to question the capability of the world’s largest central banks to keep the peace and fight off any re-emergences of financial instability. Now it seems this concern is being contemplated by the market-at-large. That doesn’t bode well for our future.
A Sudden Fixed Income Interest When ‘Recession’ Warnings Take Hold
Except for fixed income traders and economists, the yield curve is rarely mentioned in polite trader conversation or in the mainstream financial media. Its implications are too wonky for most as it can be difficult to draw impact to the average traders’ portfolio and given the considerable time lag between its movements and capital market response. Yet, when it comes to its most popular signal – that of a possible recession signal – the structure of duration risk suddenly becomes as commonplace a talking point as NFPs.
On Friday, the headlines were plastered with the news that the US Treasury yield curve had inverted along with a quick take interpretation that such an occasion has accompanied recessions in the past. There have actually been a few parts of the US government debt curve that have inverted at various points over the past months, but this occasion was trumpeted much more loudly as it happened in the comparison to the 10-year and 3-month spread (what has been identified as a recession warning even by some of the Fed branches themselves). First, what is a ‘curve’? It is the comparison of how much investors demand in return (yield) to lend to the government (for Treasuries specifically) for a certain amount of time. Normally, the longer you tie up your money to any investment, the greater the risk that something unfavorable could happen and thereby you expect a greater rate of return. When the markets demand more for a short-term investment than a longer-term one in the same asset, there is something amiss. When the markets demand more return from a three-month loan to the US government than a 10-year loan, it seems something is very wrong. Historically, the inversion of these two maturities has predated a number of us the recessions in the United States – most recently the slumps in 2008, 2001 and 1990.
First is the lead period the curve reversal has to economic contraction. The signal can precede a downturn in growth by months and even years. Preparation is good, but moving too early can ‘leave money on the table’ for the cautious or accumulate some serious losses for those trying to trade some imminent panic. Further, there are certain distortions that we have altered the course in normal capital market tributaries that could be doing the same for Treasuries and therefore this reading. More recently, the revived threat of the US government shutdown through December and the unresolved debt ceiling debate put pressure on the asset class. At the same time, though, few believe the US would do little more than allow for a short-term financial shock in order to make a political point. Far more complicating for the market and the signal is the activity of the US and global central banks. The Federal Reserve has purchased trillions in medium-dated government debt as part of its QE program. They only started to slowly to reduce holdings and push longer dated yields back up a few years after they began raising short term rates in earnest. Their recent policy reversal only adds to the complication.
Now, all of this does not mean that I believe the US and global economies will avoid stalling out or even contracting in the near future. Between the dependence on capital markets and stimulus, the heavy toll of trade wars and nationalistic policies, and the pain for key players in the global web; there is a high probability that we will see an economic retrenchment in the next few years. That said, that wouldn’t make this particular signal a trigger (causation) or even correlated through the main forces that would bring on a recession. Nevertheless, yelling ‘fire’ in an a panicky crowd on foggy day can still yield volatile results.
Brexit, Just Winging It
Another week and another upheaval in Brexit expectations. Through much of the past year’s anxiety over the withdrawal of the United Kingdom form the European Union, there was at least some comfort to be found in the finality of the Brexit date (March 29th, 2019). While it could end in favorable circumstances for financial markets (a deal that allows considerable access for the UK) or acute uncertainty (a no-deal), at least it would be over. Well, that assurance is as clouded as the expected outcome from the negotiations themselves. Shortly after I wrote the Brexit update last week whereby there was a clear timeline for another meaningful vote on the Prime Minister’s proposals – after Parliament voted for an extension of negotiations – the Speaker to the House of Commons thwarted the effort when he said the scheme would not be reconsidered unless it was materially different. It is likely that see another significant change in this drama any times (and even multiple times) this week.
At Prime Minister May’s request, the European Commission agreed to an extension of the discussions beyond the original Article 50 end date for this coming Friday. Yet, where the PM intreated a postponement out to the end of June, the EU agreed only to May 22nd – the day before European Parliamentary elections. Beyond that date, the UK would theoretically remain under the regulations and laws of the EU but would have no say in their direction which wouldn’t appeal to either side. So, now we are faced with another ‘fluid’ two months of critical deadlines.
This week, it has been suggested the government will try to put up once again for a meaningful vote – though it is still not clear whether the proposal will be meaningfully different (the EU has offered no further concessions) or there has been a successful challenge against the Commons speaker. When this could be put up to vote is unclear, but it has been suggested between Monday and Wednesday. If the proposal is approved, the timeline to May 22nd will remain and we will start to see a genuine path form. If it is not, then the following week Parliament will have to indicate that “they have a way forward”. If they do not, an extension or no deal will likely be considered for April 12th – out to the previously mentioned May 22nd date. If we pass April 12th without a clear plan, the probabilities of a ‘no deal’ or ‘no Brexit’ will rise significantly. Those two scenarios are extreme and on the opposite end of the spectrum. From a Pound trader or global investor considering UK exposure, you can imagine what a situation where the probability of diametrically-opposed, market-moving outcomes are considered balanced would do to the markets. It will curb market liquidity and leverage uncertainty. That would translate into divestment, difficulty establishing trends and serious volatility. If that isn’t your cup of tea, it is best to seek opportunities elsewhere for the next few months until this is sorted.