Monthly economic webcast:

• Here is our latest monthly economic webcast: A new year, thank goodness

Dovish central banks:

• We have tended to view stock market angst as the product of two macro issues: slowing growth and higher interest rates. The former remains a pressing issue, but the latter is starting to fade.
• The bond market and central banks are both sensitive to economic conditions and broader market sentiment. Any intense economic or market downturn usually translates into lower bond yields through risk aversion and more dovish monetary policy.
• Precisely this has happened over the past two months. The bellwether U.S. 10-year yield has plummeted from 3.24% to 2.69%, reducing the stress on borrowers. Meanwhile, central banks have also become more dovish.
• The Fed had already conveyed a slightly dovish message at its December Federal Open Market Committee (FOMC) decision. But, recognizing that markets were not fully appeased, Fed Chair Powell delivered a follow-up speech on January 4th, saying that the Fed “will be prepared to adjust policy quickly and flexibly” and “will be patient as we want to see how the economy develops.” This points to a central bank no longer mechanically wedded to rate increases.
• That said, the market may be pushing this newfound sympathy too far, now pricing in a greater probability of a rate cut than a rate hike in 2019. Rate cuts are entirely conceivable if a recession scenario plays out. But it is still more probable that the U.S. economy continues to grow in 2019 and that the Fed therefore ekes out a rate hike or even two.
• Dovish central banks are also on display elsewhere.
• China’s PBoC delivered a larger-than-expected cut to its Reserve Requirement Ratio, providing the equivalent of around US$120 billion in monetary stimulus. This is part of a broader stimulus effort designed to stabilize China’s decelerating economy.
• The Bank of Canada is widely expected to keep its target for the overnight rate unchanged on January 9th – in sharp contrast to market expectations that up until early December stood well above 50%. Remarkably, the market now assigns no chance of a rate increase, and a 19% probability to a rate cut. The argument for the latter rests on slowing global and Canadian growth, financial market turmoil, and low Canadian oil prices. A rate cut is not utterly impossible, particularly with memories still fresh of a surprise rate cut in January 2015 that was in response to a similar swoon in oil prices. However, the Bank’s most recent communications have continued to talk about the need for further rate increases, not cuts. Similarly, the latest Business Outlook Survey held up fairly well. As such, a dovish pause is by far the most likely outcome.
• All of this global monetary support should provide a measure of support for risk assets, though the other challenge – that of slowing growth – remains largely unresolved.

Government shutdown:

• The U.S. federal government shutdown continues to dribble along, now reaching 17 days. This makes it far more serious than the two other shutdowns of 2018, and slightly longer than the 16-day shutdown of 2013. In fact, if the shutdown lasts through January 12th, it will become the longest on record.
• Fortunately, the damage from the shutdown is still fairly small. As a loose rule of thumb (and likely erring on the side of pessimism), every week of a shutdown subtracts around 0.05ppt from U.S. annual GDP growth. But that figure may be too high, as a portion of the lost output is usually recouped once the shutdown has ended, and this particular shutdown also affects a smaller fraction of the federal government than usual. Many federal departments have been pre-funded through September 30, 2019. So, only 380,000 out of more than two million federal employees are not working, with another 420,000 working but temporarily not receiving pay. The affected government agencies are responsible for just 25% of the federal government’s output.
• As such, the government shutdown is unwelcome and doing subtle damage to the U.S. economy, but we will not grow truly worried unless it extends for several additional weeks. At that point the economic damage would start to become palpable. While the ascension of Democrats to the leadership of the House of Representatives makes a deal even more difficult than it was in December, we still think some sort of solution is possible that provides limited funding for border security, paired with renewed work permits for “Dreamers.”

Vicious-circle watch:

• As a key gauge for whether markets will stage a concerted rebound or revert to a declining trend, we are now watching measures of economic confidence quite closely.
• This will determine whether a vicious circle sets in. Slower economic growth contributed to financial market weakness. The question now is whether financial market weakness will, in turn, exacerbate the economic slowdown.
• So far, we have been impressed and even a little bit surprised that confidence metrics have not retreated more.
• Yes, some measures of consumer and business confidence have lost ground, but not to distressing levels. Notably, the ISM Manufacturing index fell from 59.3 to 54.1 in December, with an even larger drop in the New Orders subcomponent. These are large declines, but the headline level is still consistent with solid economic growth.
• The ISM Non-Manufacturing Index held together much better, merely dipping from 60.7 to 57.6.
• The latest U.S. payrolls report managed a whopping 312K job gain, well ahead of expectations and powerful by any definition. Granted, this last measure is not an explicit gauge of confidence.
• Some pain is trickling through, but given this mixed evidence, it remains unsettled whether there is another shoe about to drop for financial markets.