The Market Today
Fed in Transition
by Craig Dismuke, Dudley Carter
THE FED IN TRANSITION
The Federal Reserve is likely to hike rates again today despite growing risks to tighter monetary policy. Fed officials have telegraphed the decision in a similar fashion to previous rate hikes; the markets are expecting and have priced in the move; and U.S. economic data, apart from housing, have been strong. However, there are two concerns which should be compelling enough to change the path of future policy decisions.
First, the markets have signaled growing unease in monetary tightening and global growth. The belly of the yield curve inverted two weeks ago. And while this is not the primary yield curve indicator for a looming recession, it was a noteworthy event and made investors even more skittish. The real volatility has been in the equity markets. The S&P is now down 4.8% YTD and 13% in the last three months. Moreover, 56% of the S&P 500 companies are now in “bear markets” (stock prices down more than 20% from recent peaks), while another 26% are in “corrections” (down more than 10%). If the Fed hikes today, it will be the first time they do so with stock prices lower than they were at the time of the preceding hike since June 2006 (the last hike of the previous expansion).
The recent volatility has not just been limited to the U.S. markets. Of the 50 countries in the MSCI world indices (both emerging and developed economies), 46 currently have stock markets with 50-day moving averages below their 200-day moving averages, the so-called “death cross.” Almost $17 trillion has been wiped from global stock market values since peaking back in January. All of this has occurred as the ECB has continued growing its balance sheet and kept its overnight rate at -0.40%, the Bank of Japan has continued growing its balance sheet and kept its policy rate at -0.10%, and the Fed has slowly tightened its policy. How much more volatility can be expected when the ECB and BoJ attempt to raise their overnight rates into positive territory and discontinue supporting the markets with large-scale asset purchases?
Second, the primary impetus for tightening policy is containing the risk to excessive inflation. That risk appears benign at this point, particularly if a global slowdown is underway. The Fed employs econometric models which presume inflation will increase when the labor market tightens. However, recent experience shows an unemployment rate that has been below what Fed officials believe is sustainable longer term for two years now. Despite that, wage growth has sluggishly crawled to 3.1% YoY. Inflation has remained anchored near 2.0% with core PCE actually pulling back to 1.8% in October. Market-based inflation expectations remain low. While the models may say the risk to inflation is too high thus warranting further rate increases, the results show that this economy is behaving differently than the models project.
Stock prices are clearly reflecting growing angst over monetary policies and the global growth outlook. From these signals, it appears that the Fed is very near an equilibrium rate (neutral), if not already there. If inflation risks are contained, as it appears they are, the recent tightening of financial conditions should be sufficient data for the Fed to pause at least one part of its tightening – its rate hikes.
Mortgage Apps Decline; Existing Home Sales Expected to Fall: Mortgage applications for the week ending December 14 fell 5.8% on a 6.8% drop in purchase apps and a 2.3% decline in refis. The results wiped out most of the past three weeks’ reports showing positive application activity. At 9:00 a.m. CT, the November existing home sales report is expected to show another 0.4% decrease in sales.
FOMC Expected to Hike but Transition Policy Stance: However, this week’s biggest event comes at 1:00 p.m. CT today, the results of the FOMC’s final 2018 meeting. The Fed is expected to hike another 25 bps but shift its forward-looking descriptions/projections to be less confident, less hawkish, and more data-dependent. As discussed above, the Fed is now at a transition point where policy decisions need to become less mechanical and more reactionary. The focus will be on the Statement language, the Dot Plot, and Chairman Powell’s press conference. Incidentally, only one official near the middle of the pack would need to lower their dots in 2019, 2020, 2021, or the longer run to cause the medians to drop.
Yesterday – Oil-Price Plunge Pulls Equities and Treasury Yields Lower: An interesting day on Wall Street saw stocks give up most of their early gains and Treasurys rally (yields decline) as oil prices plunged. The Nasdaq gained 0.45% as tech recovered, the Dow rose 0.35%, and the S&P 500 held (+0.01%) at its lowest level since October 2017. The S&P had earlier risen as much as 1.1%. Less than half of the underlying companies gained Tuesday, led by those in the consumer discretionary sector with online retailers out in front. Energy companies dropped over 2.3% and closed at the bottom. Losses for the sector piled up as U.S. WTI collapsed 7% to below $46 per barrel and its lowest level since August 2017. The general risk-off tone and continuous conversation about a growing global supply glut has punished oil prices over the last two months. Five-year inflation expectations priced into TIPS yields fell to 1.58%, just above the post-election low from June 2017, and have lost 0.49% (from 2.17%) since oil’s 40% collapse began in early October. Nominal Treasury yields slid as investors fled riskier assets. The 10-year yield fell 4.0 bps to 2.82%, the lowest since late August, while the 2-year yield dropped 4.8 bps to 2.64%, the lowest since early September. The action in shorter maturities occurred alongside another repricing of the Fed’s rate path in 2019. While a rate increase later today remained well priced in, markets ended Tuesday expecting forward Fed Funds to peak at 2.52% (November 2019), the lowest for the November futures contract since May.
Overnight – Oil Stabilizes, Italian Assets Rally on Budget Deal, Fed Countdown Begins: Following another mixed day across Asia, equities have found support during European trading and futures are indicating the U.S. indices will rise at the opening bell. With the Fed’s big decision drawing nigh, Treasury yields had recovered from an overnight decline and were marginally changed heading into U.S. trading. After yesterday’s 4.0 bps pullback, the 10-year Treasury yield dipped another 2 bp at the open of the overnight session and briefly broke below 2.80% for the first time since May. The 2.80% level has been a key technical level that yields have bounced higher from several times during 2018. In a quiet day for the foreign data, Japan’s export growth missed estimates and posted the second weakest month since November 2016. Trade data from the world’s major economies has received extra scrutiny amid the U.S.-China trade tussle and fears of slower global economic activity. Italy’s FTSE MIB outperformed other major European indices after the European Commission announced the reduced budget deficit in the country’s most recent fiscal plan “is not ideal but it avoids opening the excessive deficit procedure at this stage and it corrects the situation of serious non-compliance.” In a relatively quiet session for European sovereign yields, Italy’s 10-year yield sank 17 bps on the news. The risk premium of Italian debt relative to German’s sank to 2.53%, the lowest since September. Oil firmed up after yesterday’s free fall but U.S. WTI remained below $47 per barrel.