Back to the Fed

The midterm election is over. So we can go back to worrying about the Fed!

I ended yesterday’s political economy piece saying:

My sense, here, is that a divided Congress means we are in a ride it out period economically. There are no more big fiscal plays coming on that front until after 2020. Going forward, the economy, is, therefore mostly about momentum and the Fed.

So let’s discuss this for a bit.

Global growth is slowing

The question is not whether global growth is slowing. It is whether that slowdown will fully encompass the US. If you look at predictive econometric models, I like what Gavyn Davies has shown over the past business cycle. So let me quote from his latest at the FT. Here’s how he starts:

The drop in global equities in October was remarkable for its extent, the frequency of consecutive negative days, and the synchronised decline in all the major markets. The most likely fundamental trigger for the severity of the equity correction was an increase in investors’ perceptions of downside, or even recessionary, risks to the global economy. Dramatic talk about trade wars obviously exacerbated the drop in confidence.

His conclusions:

The flow of economic data… suggests that there was, indeed, a decline in world activity during October. In fact, the global growth rate clearly peaked late in 2017, since when there has been a noticeable reversion to the mean. The period of above-trend growth that was so powerful last year proved short lived, and now seems to have been mainly cyclical, rather than secular, in nature.

I think that’s exactly right. Now, one could argue that this is yet another mid-cycle slowdown akin to the shale bust in 2015. Moreover, the Fed at least has more firepower to deal with this. I wouldn’t completely discount that view and the potential for a soft landing from Fed hikes. But I am more worried about downside risks from over-tightening here – and I have been since late 2017 when I wrote about this being the most dangerous part of the business cycle.

Wall Street Says Fed Is in Denial

Here’s an interesting story from Bloomberg about where this is heading.

Here’s the scoop:

Fixed-income traders are telling the Federal Reserve that it might end up making a big policy mistake.

And it’s not just rising interest rates they’re talking about.

A more pressing concern has to do with the Fed’s crisis-era bond investments. Since October of last year, the central bank has been steadily reducing its holdings of Treasuries and mortgage-backed bonds. But as the unwind has picked up, unexpected knock-on effects are emerging in overnight lending markets, where demand for short-term cash has been on the rise.

Fed officials, who are meeting in Washington to discuss monetary policy, have pooh-poohed the idea that they are to blame and point to various technical factors. Yet a growing number on Wall Street aren’t buying it. The most vocal critics contend that if the Fed doesn’t slow or stop its unwind, it could end up draining too much money from the banking system, cause market volatility to surge and undermine its ability to control its rate-setting policy.

“The Fed is in denial,” said Priya Misra, the head of global interest-rate strategy at TD Securities. “If the Fed continues to let its balance-sheet runoff continue, then reserves will begin to become scarce.”

I don’t know if I buy into this, frankly. The issue here is an alleged scarcity of reserves at small and medium-sized banks due to Dodd-Frank requirements tying up reserve capital. And so I see this is Wall Street lobbying for reduced regulatory control, an argument to pare back Dodd-Frank. Nevertheless, I am flagging it as something to store away just in case it has some validity.

My concern is credit

In my view, the real question is credit distress. As I said on Wednesday, I think we are in a relatively fiscal-free environment here, where the economy flies on its own momentum. The only thing impinging on that momentum is the Fed, then. And since the Fed is tightening, the question is whether the Fed is behind the curve, just right, or over-tightening.

Because monetary policy acts with a lag, it’s a hard question to answer. That’s the problem. Right now, things look just fine in the US economically. GDP growth was 3.5% annualized according to recent data. GDPNow is tracking 2.9% for Q4,, which is still relatively healthy. Jobless claims came out today showing an average of 213,750, a 45-year low. And the unemployment rate is at 3.7%. There’s nothing wrong with that picture at all.

And, if you look at high yield as a proxy for early signs of distress, the picture also looks good. The equities-linked downdraft ended in late October. Now, high yield is back in business. I would worry when spreads move above 5%. Now, they’re well below 4%.

So, we’re in a bit of a holding pattern here.

Back to the global picture

The US is not going to escape the global growth slowdown. That’s for sure. The picture looks like this, according to Gavyn:

According to the latest nowcasts, activity growth in the world economy has slowed from a peak of 5 per cent a year ago to only 3 per cent now, about 0.7 per cent below trend. Much of this decline has occurred in the last couple of months.

Growth has declined almost everywhere. China has slowed from 7.4 per cent a year ago to 5.3 per cent now, the lowest growth rate since the serious downturn in 2015. The Eurozone has also reported disappointing data throughout 2018, and the latest dip in October has taken growth down to only 1.1 per cent. In contrast, the US has been a beacon of strong growth throughout the year, bucking the global pattern.

How long can this dichotomy last? And how long will it drive the substantial monetary policy divergence which results from it, with the Fed much more aggressive than everyone else? With the tax cut bump in the rear view mirror, and no additional fiscal bump coming, I think we will find out in 2019.


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