The Fed Finds Themselves in a Market, Economic and Credibility Quandary
There is a lot of high-profile event risk – both data and events – on the docket this week. The distinction of importance for these potential catalysts is defined by their capacity to tap into more systemic fundamental themes. By that evaluation, there is a lot that can further shape our collective interests/concerns through trade wars, concerns over stalled global growth and the inadequacies of monetary policy as a financial firefighting tool. However, the most influential among the deluge will be the event/s that can reach as many of the major themes as possible. Naturally, there is connection between the aforementioned matters: earnings is an economic benchmark, trade wars stunt growth and recession threatens to expose central banks lack of tools.
I would argue that the most loaded item on the menu is Wednesday’s FOMC (Federal Open Market Committee) meeting. This is not one of the quarterly meetings for which we expect the Summary of Economic Projections (SEP) and upon which every rate hike that has been pushed through in this cycle occurred. That won’t preclude a significance to this update however. The interest in this event is more a product of the broader market circumstances rather than an anticipation for any change in rates or unorthodox policy. There is essentially no anticipation for change at this meeting but there is approximately a 65 percent chance of a cut by year’s end according to Fed Funds futures. That is a dramatic reversal of course from where we were at 8 months ago. Before the market’s epic tumble through the fourth quarter (yes, market performance and policy intent are connected), the Fed’s members expected three rate hikes this year while the markets believed it would be more on the order of fourth hikes.
What prompted this dramatic about face? Inflation forecasts were generally in line with the central bank’s targets and the unemployment rate is still hovering around its multi-decade low. That would put the onus on forecasts and external factors. The assumptions of follow on pain from the government shutdown and year-end financial market volatility clearly shaped expectations. Therein lies the problem. The US markets have recovered dramatically through the past four months. Trade wars are still a burden with the threat that they will spread to envelop the US and European lines, but the US-China relationship seems to be improving materially. And, just this past week, the 1Q GDP release signaled that we wouldn’t see the world’s largest economy stall out in the immediate future with a 3.2 percent annualized reading – though the inflation figure that is derived from that comprehensive data notably dropped further below objective. Market’s cheered the general dovish shift by the world’s largest central banks, and none offered more relief than the Fed’s turn off of a steady course of rate hikes.
So, what is the US central bank to do? Most likely they will default to patience with status quo settings through the foreseeable future. Meanwhile, the White House will continue to berate the Fed for not doing more and the market’s will cry out with any stall in the climb from indices. If there is a sharp drop in output potential for the US economy through the second quarter, response rate will be delayed owing to the strong 1Q figure, and that in turn may raise the interest in financial market performance to avoid late response. In this environment where everyone has different views on what the next stage will be for economic and market health, even the status quo from the Fed will draw out concern from some and speculative leverage from others.
Earnings Season Fades as Trade Wars, Recession Fears and Monetary Policy Return
Raising our focus from the top event to the steady drumbeats of more systemic fundamental issues, there is reason to anticipate the range of frequent systemic winds these past months to once again sweep across our markets. Before the ‘oldies’ to return to form, we will first see the recent top headline relinquish its influence. Earnings season in the US technically extends for a few more weeks, but the number of economically-important companies issuing their numbers to tout a greater influence over global growth forecasts or shape the other systemic matters in the financial system is dwindling. Most of the top listings are concentrated to the first two days of the week. Google and Apple will tap into the speculative leverage of the tech sector, Eli Lilly and Pfizer hits the worst performing major sector of late, General Motors will weigh in on trade wars, and General Electric will be another representative blue chip.
Shifting the focus back to monetary policy, the Fed decision is the obvious focal point while the Bank of England decision is essentially a reflection of Brexit concerns. Beyond the official meetings, we should keep tabs on regular data and any sign that participants of the financial system are starting to question the capacities of central banks to foster growth and avert market crises. Speaking of economic activity, the sentiment around this fundamental health gauge has certainly jogged higher these past weeks. Both the US and Chinese 1Q GDP readings beat expectations – though the latter’s beat simply avoided a further multi-decade low.
We have another official growth reading from a key economic center: the Eurozone figures. Yet, as we have seen from speculation preceding these official figures, fear can arise from less-comprehensive monthly data or even external measures like the US yield curve inversion. Trade wars will once again prove the least predictable overarching concern. Through the end of this past week, President Trump once again suggested he expected his Chinese counterpart in the US soon (insinuating a deal they could sign) while President Xi echoed a similar belief that the end of the negotiations is within sight. As for the market’s interest and ability to leverage this belief; headlines such as the second largest Chinese e-commerce companies being put on the US blacklist raise concerns, we have already seen the markets recover significant lost ground (‘erase the discount’), and new fronts threaten to open on the global trade war. Should Trump follow through on any of his three general threats against the EU (the $11 billion in tariffs in retaliation for Airbus subsidies, the loose threat to seek retribution for trade restrictions on Harley-Davidson earnings and the general threat to put levies on imported autos and auto parts), the market is unprepared and the ultimate economic impact would be far more severe.
A Spat of Breakouts a Plenty of Reason to Question Conviction
I’ve weighed in on this question before, but the occasion calls for a revisit: what constitutes a true breakout? We just happen to be facing potential technical breaks for the benchmark for global equities, the FX market and commodities. And, a side note before we delve in on the topic: ‘breakout’ is a non-directional term. Owing to the default long-only perspective of so many market participants (particularly those in equities), the association is immediately made for ‘favorable’ developments. If we are experiencing a bullish clearance from congestion, the proper term is a ‘breakup’ or ‘bullish break’ while the opposite conclusion would be a ‘breakdown’ or ‘bearish break’.
With quibble out of the way, we have certainly witnessed some charged technical intent this past week. The most remarkable breaks would come from US indices which found the Nasdaq drive to record highs while the S&P 500 hit a technical high on the close, the DXY Dollar index surged through a near two-year range high which translated to EURUSD sliding below 1.1200, and crude oil tumbled through $65 and then below its 20-day moving average for the first time in 50 days (the longest bull run in years). For many, a technical cue is all that is needed to register a break, and the switch flips in their minds to expect a committed move to follow in the marker’s wake. That is supremely presumptuous. What if very few traders considered the same level relevant and therefore there was little intent to drive the market following the ‘break’ that an individual may have put emphasis on? I live by the axiom: it isn’t about the break, it’s the follow through. Yet, follow through is the result of intent. While sheer speculative appetite or an extremely popular technical level can occasionally heft its own influence over the market, the case is a rare one. Far more common in successful technical breaks evolving into robust modes of follow through is a scenario that involves a fundamental motivation that can help secure the tentative break but more importantly draws more speculative interest in or fuels the absolute need to abandon the market.
With the aforementioned three market leaders, we should consider their motivation rather than just the fact that they surpassed their technical boundaries. Crude oil’s slump through the end of this past month is the least convincing of the three. It’s tumble seems to have a very particular catalyst in President Trump’s suggestion that he reached out to OPEC members to encourage them to lower the market price for the commodity. Given the spotty record of his demands and the subsequent market movement over the past year, a bearish drive will depend far more on either a clear downturn in global growth and/or a systemic drop in risk trends. From US equities, the Nasdaq Composite readily cleared its previous record highs from September/October and extended the move beyond that level. That said, the S&P 500’s break was purely ‘technical’ with a new high based on a close over close basis. There were no intraday highs. Meanwhile, the Dow hasn’t even reached its previous high. Robust growth or a chase for yield are the best motivators for equities, but that seems far-fetched in our present environment. The Dollar arguably holds the most probable bullish scenario. The currency can find charge from more favorable relative growth or through a rate advantage leveraged through more dovish counterparts. Alternatively, a full-tilt global risk aversion can revive the Greenback’s absolute haven status. At present, neither end of those extremes seem probable, but they can certainly arise.