"...after a while i stopped to rebel” Biggest mistake, Rolling Stones
Since our last post, there has been something of a rotation of the dominant factors driving the global macroeconomy. The predominantly political factors that have heightened attention and volatility over recent months have remained, but as we move towards the end of a very complex and diverse year for financial markets, the past week has been dominated by the monetary policy trajectory of those central banks deemed most dominant for global financial markets - and more specifically how that trajectory has been altered by the evolving economic and geopolitical backdrop.
Last week we discussed the latest assessment of the internal and external backdrop from the ECB and how despite stating that the balance of risks were "moving to the downside”, that the ECB confirmed their plan to end their QE programme in 2018. Over the coming months, markets will be closely assessing whether the ECB’s decision to end the monetary accommodation of its QE programme into a near concerted global slowdown was a policy misstep.
In the buildup to last night’s US rate decision, there had been a near crescendo of rhetoric from analysts, high-profile investors and even President Trump, suggesting that it would be a mistake for the Fed to raise rates, despite the fact that the market implied probability for a rate rise was around 70% going into the event. The premise of the argument against raising rates was varied. President Trump emphasised the implications for the equity markets - long heralded by his administration as a barometer of the success of his economic policies. From other corners, however, the warnings were more credible: from the sharp deterioration of the global export dynamic to rising tensions in credit markets, not to mention the deflationary impact of the recent very sharp decline in oil prices. A slowing global growth dynamic, it was argued, had seen sufficient tightening of financial conditions (higher credit spreads, lower equities and a stronger USD) and thus rates should be put on hold.
"Till I reach my highest ground” Red Hot Chilli Peppers, Higher Ground
From our perspective, however, we were - and still are - a little way away from a Fed pause. Powell acknowledged that inflation was ending the year more subdued than expected and that some cross currents have emerged since the September FOMC. However, Powell signalled that those developments had not fundamentally altered the outlook. Indeed, while the FOMC projections (the ‘dots’) show a modestly lower path for Fed Funds than in September (2 further hikes in 2019, from 3 in September), the lower dot plot should support the continued "strong economy”.
If global economic deterioration and weakness in credit and equity markets continue, we would anticipate that the Fed will pivot further towards pausing policy. However, the worst thing the Fed could do would arguably be to adopt an immediate dovish bias based upon the extrapolation of the current (and in many cases only very recent) weaknesses. That would only act as to increase volatility. Indeed, if, as we expect, the idiosyncratic weakness in Germany and Italy are corrected in Q4/Q1 and the impending China fiscal stimulus has a positive effect early in 2019, then the global economy will appear on a much firmer footing.
Further, the Fed have reiterated their determination to get rates to, or as close to an immeasurable target as is possible, before becoming more fully data dependent - which may or may not imply a pause when they get there. For us, that is at the very least after a further 25bp hike in March - and possibly another in June. In the approach to equilibrium the Fed are clearly trying to give themselves greater optionality around monetary policy, removing forward guidance, widening the gap between the IOER and the top of the target range. With strong growth, inflation at target, a tight labour market and rising productivity and wage growth, the mistake would have been not raising rates.
"Help them fall back in this cycle” End of the Beginning, Thirty Seconds To Mars