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by  Eric Lascelles Jul 30, 2019

What's in this article:

  • Economic Compass
  • Fed preview
  • Dollar weakness
  • Data run

Economic Compass:

Fed preview:

  • The next U.S. Federal Reserve rate decision occurs this Wednesday July 31.
  • The market fully prices in a rate cut for the meeting. This is an important fact, as the Fed does not like to deliver big surprises. This is not to say that the market leads the Fed around by the nose. Instead, the Fed carefully leads markets toward a particular conclusion by leaning into market expectations in one direction or another until the correct hypothesis has been formed. Thus, we can be reasonably confident that market expectations will be fulfilled.
  • The previous FOMC (Federal Open Market Committee) statement hinted of coming monetary easing with the promise that the Fed “will act as appropriate to sustain the expansion.” Fed Chair Powell has also delivered recent testimony containing the line “uncertainties around trade tensions and concerns about the strength of the global economy continue to weigh on the U.S. economic outlook.”
  • A variety of Fed speakers have explicitly voiced their support for near-term rate reductions, including such luminaries as New York Fed President Williams and Chicago Fed President Evans.  For what it is worth, ex Fed Chair Yellen has also endorsed a rate cut.
  • It is slightly unusual that the Fed is seemingly on the cusp of initiating a new direction for monetary policy at one of the central bank’s “minor” meetings. The Fed only updates its economic outlook and dot plots at four of its eight annual meetings (regarded as “major” meetings by the market), and July 31 is not one of them.
    • That said, the Fed has made a point of de-emphasizing the distinction between the two types of meetings. In fact, it reduced the distinction at the beginning of 2019 by introducing press conferences after every meeting rather than merely the four major events.
    • Furthermore, one can argue that the crucial moment in the Fed’s recent pivot is not so much its imminent delivery of a rate cut, but in successfully guiding market expectations toward that outcome at the prior meeting. This was done with the considerable assistance of the updated dot plots that were released at that time. As such, it made sense to provide guidance at a major meeting followed by action at the trailing minor meeting.

The Fed’s motivation:

  • The Fed’s motivation is arguably twofold: to deliver an insurance cut, and to fend off low inflation expectations.
  • The pursuit of insurance rate cuts is somewhat out of character for the Fed (and central banks, more generally). Traditionally, central banks conduct policy in response to their base-case economic scenario, paying less heed to the distribution of risks around that central forecast. However, this central bank is very clearly in scenario mode. It’s delivering cuts not so much because the base-case scenario demands it (it doesn’t, and indeed the Fed’s own growth forecast has remained unaltered over the past quarter), but because there is a larger-than-normal downside risk due to a mix of factors, including:
    • protectionism
    • slowing global growth
    • an aging business cycle
    • geopolitical tensions with Iran.
    It is not standard operating procedure. But it is entirely justifiable and arguably even commendable for the Fed to be more explicitly factoring in these alternative scenarios given their substantial weight.
  • The Fed’s second consideration relates to low inflation expectations. To be clear, the issue is not so much realized inflation, which is not far below target. In fact, it is arguably even at or above target when more sophisticated trend measures are considered. Rather, the problem is that inflation expectations for the more distant future are low. Given Japan’s long-standing inflation undershoot, as well as Europe’s more recent woes, the risk of “Japanification” seems far from trivial. At the same time, let us not exaggerate the U.S.-specific risk. While 5yr-5yr inflation expectations are low, they have also rebounded by more than 20bps since late June. They are notably above the 2016 decade low. And, at 2.02%, are only around half a percentage point below their historical norm.

How big of a rate cut?

  • The market prices in a 77% chance of a 25bps rate cut versus a 23% chance of a 50bps rate cut.
  • We concur that the smaller stimulus is the more likely of the two.
  • Although recent Fed easing cycles have begun with 50bps moves, it makes sense for the Fed to be more cautious this time. The main reason is that interest rates are themselves compressed. With only 225bps of potential stimulus to deliver before crashing into the zero lower bound, the Fed must be judicious in its actions. There is already evidence it recognizes this. Its just-concluded tightening pattern was more cautious than prior tightening cycles, predominantly coming in the form of 25bps rate increases at every second meeting rather than at every opportunity. Easing may thus also occur at “half speed.”
  • Further arguing against a 50bps cut, economic data since the last FOMC meeting has not been as weak, due in part to:
    • improved payrolls
    • rising durable goods orders
    • higher inflation expectations.
    And let us not forget that the Fed’s dot plots only had eight out of 17 participants recommending easing. It is a high enough hurdle to bring most voters on board, let alone convince them to engage in an aggressive act of stimulus. Furthermore, none of the votes for rate cuts recommended more than a total of 50bps of easing across the entirety of 2019. It would be unusual to deliver a year’s worth of stimulus all in one meeting. It is more likely that it dribbles out over several meetings.
  • But the Fed will have to operate carefully if it does opt to deliver “just” a 25bps rate cut. The Fed probably won’t want the stock market to sell off on the day of its very first rate cut. The whole point is to boost growth and sentiment. While a 50bps cut isn’t truly “expected,” it is partially priced in. Thus, the Fed will likely have to insert some more stimulative language into its statement and trailing press conference to keep markets content even as they price out the glimmer of a 50bps move.
  • Looking out to the remainder of the year, the market prices in a total of 75bps of cuts. Investors then assume slightly more easing in 2020.
  • We think the Fed may ultimately deliver slightly less stimulus than expected over this period, mainly because further economic growth is more likely than contraction. However, financial markets are already quite efficient at pricing in central bank actions. Also, it is fair to note that over a multi-year period, central banks usually move further in their chosen direction than the market initially expects.

Implications:

  • Fed rate cuts help to justify low bond yields. They also help to justify the current risk-on attitude in financial markets. And, the cuts are theoretically a driver of economic growth.
  • Whether or not rate cuts should ultimately be celebrated comes down to which of five possible considerations ultimately dominates. Two are positive, three are negative:
    1. If monetary stimulus successfully smooths over the economic hole left by recent protectionism, it could well extend the economic cycle by restoring confidence at a precarious moment.
    2. If monetary stimulus manages to generate supply-side growth – a productivity boost – then economic growth can be faster without overheating and/or the economic expansion can last longer.
    3. On the other hand, if monetary stimulus delivers demand-side growth – more hiring and the like, which is the more normal result – it may accelerate economic growth but at the expense of pulling forward the end of the cycle.
    4. Of course, it goes without saying that every rate cut depletes the Fed’s reserves of dry powder and so limits its actions should more serious economic headwinds blow at a later date.
    5. Finally, the initiation of rate cuts often signifies the approaching end of the business cycle – an ominous warning, unless the Fed has managed to cut early enough to forestall the economic swoon.
  • For the moment, the market is interpreting rate cuts in a positive rather than negative manner. This is probably the right framework to use for the moment, at least until there are signs that the market is becoming more attuned to less favourable interpretations.

U.S. dollar weakness:

  • The U.S. dollar has recently captured market attention, based on the view that it might soften in the future, possibly even aided by U.S. government intervention.
  • We concur that the dollar is more likely to fall than rise versus a trade-weighted basket of its peers over the next few years. Arguments in favour of dollar weakness include:
    • The dollar is roughly 10% overvalued.
    • From a historical perspective, it would be unusual for the dollar to continue appreciating after the eight-year run that it has managed so far.
    • The dovish Fed is a negative for the dollar.
    • American politicians – most prominently, President Trump – are actively seeking a weaker dollar, in contrast to the long-standing U.S. policy of advocating for a strong dollar.
  • Note that we don’t look for the U.S. dollar to weaken versus the Canadian dollar or pound over the next year. That may prove a more distant development. But it should soften versus the euro, yen and some emerging market currencies.
  • Of course, currency markets have a way of challenging even the most coherent forecast. The market’s focus can flit from one topic to another. Sometimes the focus is on interest rates. At other times, it is trade imbalances. It is occasionally commodity prices, while not infrequently it is a pure risk on/off attitude. Furthermore, gradations matter: slightly weak U.S. data is dollar negative, while extremely weak U.S. data can be dollar positive to the extent it triggers a safe-haven bid.
  • Accordingly, risks to our forecast include the possibility that:
    • the Fed could be “outdoved” by the ECB
    • U.S. protectionism could prove dollar positive, and
    • the arrival of a recession could trigger safe-haven flows into the greenback.

How likely are U.S. politicians to force the matter by intervening against the dollar?

  • Nothing can be ruled out given the unorthodox economic policies already pursued by President Trump. These include the application of tariffs and the pressure he has put on the Federal Reserve to cut rates. Accordingly, the current administration is surely more likely to engage in foreign exchange (FX) intervention than any of the ones that immediately preceded it. Indeed, President Trump has already complained about the effect that the dovish European Central Bank may have on the dollar.
  • Currency interventions are implemented by the executive branch of government. This means it is distinctly under President Trump’s purview.
  • There is some precedent for FX intervention in the modern era: both the Bank of Japan and Switzerland have intervened to weaken their exchange rate at times over the past decade.
  • Despite all of this, it remains fairly unlikely that the U.S. will actually intervene against the dollar, for several reasons:
    1. The U.S. has funds of $94B set aside in the event that an intervention is necessary. But this is barely a drop when compared to the roughly $5 trillion transacted in dollars each day. The point is that it would take a very aggressive effort to secure a material adjustment.
    2. Most instances of successful currency intervention require international cooperation. Switzerland did not enjoy this, and so its currency floor eventually broke. While the U.S. dollar is technically overvalued, it is not expensive enough to attract much sympathy or cooperation from other countries.
    3. The U.S. has not engaged in a unilateral currency intervention for decades. It would be rusty, rendering success even less likely.
    4. Unilateral currency interventions against the dollar would undermine the U.S. dollar’s status as the globe’s reserve currency, eroding part of the world’s trust in the currency. In turn, U.S. borrowing costs might go up and the availability of capital might worsen.
    5. To the extent that U.S. currency concerns revolve around the country’s relative competitiveness with the rest of the world, one would imagine that the Chinese exchange rate should therefore be the primary focus given that country’s 61% share of the U.S. trade imbalance. But, despite an opportunity every quarter to deem China a currency manipulator, the present U.S. administration has repeatedly declined to do so. Furthermore, even if the U.S. wanted to soften the dollar against the renminbi, it would have a very hard time cracking China’s capital controls so as to purchase more Chinese assets. And even if it did manage to buy tens of billions of dollars in Chinese bonds, there might be a public and political backlash over the optics of the U.S. government effectively subsidizing the Chinese government. To be fair, this is why experts believe the U.S. would be more likely to target the euro instead.
    6. It appears that the U.S. would rather manipulate its relative competitiveness via tariffs as opposed to its exchange rate. In fact, U.S. politicians are apparently working on a rule that would permit it to impose tariffs on any country with an undervalued exchange rate.
      • In short, the risk of intervention is higher than usual, but it is not blindingly high.
  • To the extent the dollar weakens, would that spark a significant economic acceleration? The answer depends on the timing and the definition of “significant.”
  • Let us recognize that recent dollar weakness has been only slight: the nominal, broad trade-weighted exchange rate has only fallen by around 2% since early June. It would take about a 10% decline in the dollar to add 1.0% to the level of U.S. GDP. Thus, the move would have to be rather more significant to really move the needle. A 10% currency deprecation would also add between 0.2% and 1.0% to the level of CPI and improve the current account balance by up to 1 percentage point.
  • The recent dollar weakness is even less significant than it first seems. It takes a few years for a currency’s move to fully map onto the economy. Thus, the recent dollar weakness is less relevant than the fact that the currency is still trending higher on a two-year rolling basis. If anything, the dollar is still exerting a slight cumulative drag on growth rather than providing a slight boost.
  • The good news is that this minor drag is beginning to wane and could eventually be replaced by a slight tailwind should the dollar weaken as we forecast. But the impulses are all fairly small unless a more profound and enduring shift in the currency occurs.

Data run:

  • The U.S. debt-ceiling danger has seemingly been resolved. The House of Representatives passed a bill providing a two-year extension with another $320B in spending room. The White House is on side with this, and while House Republicans voted against the measure, the Republican-led Senate is expected to approve it this week. This is good news in that it eliminates a key political risk. It also signals that a government shutdown and/or fiscal cliff are less likely later this year.
  • One further item of note is that the agreement also eliminated “sequestration.” This is a system of automatic spending cuts that kicks in when politicians cannot come to a budget agreement amongst themselves. This could result in a slightly more expansionary fiscal policy in the U.S., though not likely to any great extent.
  • The Brexit outlook has deteriorated further as new U.K. Prime Minister Boris Johnson has made it clear that the U.K. will leave the EU one way or another on October 31. The risk of a no-deal exit has surely increased given our doubts that the EU will prove willing or capable of offering a substantially different deal to the U.K. Nevertheless, let us recognize that it would just take a few Conservative MPs to flip sides for a hypothetical confidence vote to fail and trigger a very different path involving elections/referendums/extensions.
  • U.S. Q2 GDP was bad, good or ominous, depending on your perspective.
    • The initial, superficial read was one of relative weakness. The quarter saw just 2.1% annualized growth after a year in which 3% handles were much more normal, with notable weakness in business investment and trade.
    • However, a silver lining quickly became apparent as consumer spending rose by a robust 4.3%. And, much of the weakness could be explained away as being the result of:
      • declining inventories (a temporary phenomenon and a happy signal that demand well outpaced production), and
      • soft trade (with the implication that domestic demand was actually fairly good in the second quarter).
    • Most interpretations stopped there. However, there is a third, ominous interpretation. It so happens that several of the weak components are the most important variables for predicting what future GDP prints might look like. The Duncan Indicator – which teases out which GDP inputs lead others – fell in the second quarter, the first such fall since late 2015. In the end, our interpretation is that the second quarter was not as soft as it looked, but future quarters are still vulnerable.
  • U.S. payrolls preview: The consensus looks for a +165K hiring print. This is down from the prior month, but decent nonetheless and indicative of a gradually softening trend. We highlight the possibility that it could come in slightly above this, based in part on continued low jobless claims numbers.
  • ISM (Institute for Supply Management) Manufacturing preview: The consensus forecast is usually fairly smart for this release, with 52.0 expected after a 51.7 last month. The release could be particularly pivotal, in the sense that any stabilization, let alone improvement, would be a welcome reprieve after months of decline. The ISM Manufacturing Index is now at a precarious point, perched only moderately above the 50.0 threshold that delineates manufacturing-sector expansion from contraction. The global manufacturing PMI (Purchasing Managers’ Index) has already slipped below 50, though this is quite different and a much lower bar than a broader economic recession. Stronger U.S. durable goods orders and improved Empire and Philly Fed manufacturing surveys suggest a stabilization or even a slight rebound may actually be achieved.

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