"The slow motion replay doesn’t show how fast that ball was really travelling” Richie Benaud
Last week we discussed the regime shift in baseline volatility of financial markets in August as the confluence of macroeconomic and geopolitical factors, intensified. Headlines and sentiment continue to focus on the renewed trade tensions between the US and China, and the credit and risk implications of the rejection of fiscal prudence in Argentina. However, beyond the heightened volatility, we remain focussed on one core dynamic in financial markets: the progression of interest rates and monetary accommodation, and the implications for rate and yield differentials.
"Like a golfer who can’t putt, has no touch” Trump on Powell
Central to the current debate is the Fed. If you listen to the commentary of President Trump, you would be forgiven for thinking that the Fed are significantly behind the curve. Indeed, if you look at the pricing and slope of the US yield curve, you could equally be convinced that the only possible path for US interest rates is to continue lower into the foreseeable future. However, "the objectives of the FOMC, as mandated by the Congress in the Federal Reserve Act, are promoting (1) maximum employment, which means all Americans that want to work are gainfully employed, and (2) stable prices for the goods and services we all purchase” - [FederalReserve.gov]. With the unemployment rate currently below the level viewed as the equilibrium or maximum unemployment level, inflation at or around the level consistent with medium term price stability and GDP rising at above equilibrium or potential growth levels, it is difficult to argue that the Fed needs to cut interest rates by 100bps over the next year, as implied by the markets... and implored by the President.
Indeed, yesterday the CBO (Congressional Budget Office) maintained its growth projections for this year (2.3%) and, more substantially, for next year (from 1.7% to 2.1%).
Last night, the Fed released the minutes from the FOMC meeting on the 30th, 31st July, where the minutes referenced the phrase - that Chair Powell used in the press conference - that "Fed officials viewed the July rate cut as a mid-cycle adjustment”. Implying that the cut (and likely another in September) is a process of adjustment, rather than the beginning of a rate cutting cycle. Indeed, "several Fed officials favoured keeping rates unchanged in July”.
While we maintain a view that is far less dovish than the market (and thus bullish on the USD), there are some obvious caveats. Firstly, the timing of the July meeting - ahead of the escalation of trade tensions between the US and China (Trump raised the tariff threat and labelled China a currency manipulator in early August) and the surprise primary win for the fiscally profligate opposition candidate in Argentina. Secondly, the current market pricing of the US yield curve is now so extreme that it likely presents something of a stability risk were the Fed to choose not to err on the side of caution. We are much less convinced in the predictive power of the shape of the US yield curve (i.e 2s10s inversion equals impending recession) due to post GFC financial repression and the fact that the safe haven bid from the rest of the world is exaggerated by the fact that almost all of the positive yielding investment grade debt is in the US (which also has a strong economy and firm rule of law).
We remain unconvinced that the US should be cutting rates beyond September, unless the world (and the US) deteriorates further, but the case for buying USD remains strong.
"They came to see me bat, not you bowl” WG Grace, putting the bails back on his stumps after being bowled first ball
Today signals the start of the annual central bankers gathering at Jackson Hole, Wyoming. The risk to our views is that the Fed buckle to pressure from the President or (more convincingly) the markets, and offer a further dovish pivot (this time last year, the Fed were expected to raise rates three times in 2019; todays pricing would take the rate movement to more than three cuts). However, while there is no Mario Draghi at this year’s conference, our focus remains on the ECB. Chief Economist, Philip Lane, is the most likely to deliver a dovish narrative, which is likely to include rate cuts and QE among further targeted measures as the China slowdown continues to undermine the growth path of the eurozone.
From a UK perspective, the discussions between Johnson and Macron today, Johnson and Tusk tomorrow and the G7 over the weekend are important. However, the rhetoric from Merkel yesterday is likely most telling - Mr Johnson has a short window to deliver a plan to Brussels on avoiding the backstop, whilst himself avoiding having the rug pulled from under him by the UK parliament. Indeed as the 3rd Ashes test gets under way today, Johnson may well need the strategy of Joe Root, the pace of Jofra Archer and the agility and composure of (sadly missing today) Steve Smith.