Three factors that could spoil a “Powell Put”
- Enjoy the rally, but keep an eye on three major factors:
- First, US inflation expectations remain low, but could turn around in the second quarter
- Second, a dovish Fed won’t change China’s fortunes, the biggest overhang on the world economy
- Third, having rallied to sub-2.7%, the 10-yr yield outlook is asymmetric
Fed relent to sustain the ongoing market rally, but only for a few months
Flagging a host of “cross-currents”, US FOMC Chairman Jerome Powell delivered to the markets a great deal of cheer this week. Given that the market had already priced-In a dovish tilt by the Fed, it required particularly neutral language to top expectations, but Mr. Powell pulled that off. Not only did he take rate hikes off the table for the time being, he addressed the other concern raised by the buyside community through the course of 2018—the pace of balance sheet adjustment. While pointing out that the Fed will be flexible and data dependent, the US central bank has moved away from its “auto-pilot” of gradual policy normalisation.
The risk with becoming data dependent and moving away from forward guidance is that the policy outlook (or at least the market’s perception of it) may become more volatile. It will take just a handful of data points underscoring renewed strength in housing and auto sales and a few positive earnings releases to a return of fears that rate hikes are back on the table, in our view. The overwhelming wager however is that that is unlikely, as seen in the yield curves.
But let’s be clear—the Fed did not reverse policy this week. By the end of the second quarter, if growth remains comfortably in the mid-2%, the labour market remains strong, and China slowdown does not become disorderly, there will be little hesitation to hike, in our view. Hence the move from sharp flattening to steepening could well be on the cards in a matter of months. At the other end of possibilities, a few more months of weak data may warrant yet another asset market tantrum and strident calls for a reversal of quantitative tightening. Either way, we think that the Fed has bought no more than a few months of financial market stability.
Under current conditions, it would be reasonable to expect for continued equity market rally, further flattening of curves, and strong support for emerging markets. The USD has corrected lately (although the DXY is still up more than 5%yoy), and can be expected to remain flat or a tad weaker. But our conviction is low with respect to the durability of this narrative.
Note a few complicating factors for the period ahead:
First, US markets are by no means cheap. The Case-Shiller cyclically-adjusted price-earning (CAPE) ratio for the S&P500 is close to the highest point seen in recent memory, and the ratio may well rise further given the mixture of softening earnings growth and rebounding stock prices. This points to limited upside for the market, which in turn means repeated demands for the “Powell Put” going forward. Particularly relevant in this context is the fact that a dovish Fed won’t change China’s fortunes. Increasingly, earnings of large companies rely on Chinese demand, hence its sustained slowdown would remain a major overhang in the near term.
End-year data. Jan 30 for 2019
Source: Bloomberg, and http://www.econ.yale.edu/~shiller/data.htm
Second, contrary to the complaints about quantitative tightening creating a credit crunch, interest rates are exceptionally low, with real long term rate (derived from the difference between 10-year bond yields and average annual inflation) hovering at around 0.5%. This is not consistent with an economy growing at well above its rate of potential GDP growth. Unless growth or inflation rates slow sharply, nominal and real rates would have to rise this year. Given that US government deficit and debt are rising, with no consolidation effort likely to come from a highly antagonistic Congress and White House, Treasury issuance will continue to balloon. This can readily cause a reversal of the flattening trend.
Third, the utter lack of concern about inflation (as seen in the pricing of 5-year breakeven points) could come back to haunt the market even if growth does not jump sharply. The US labour market is tight and wages are rising, the price of oil may well have bottomed, and a China stimulus could buoy a broader range commodity prices. Short of a deterioration in the job markets, the scenario around inflation seems asymmetric to us. i.e. the chance of a downside surprise is smaller than an upward surprise. The market is not at all considering that.
With this background, we will keep our eyes on three matters that could spoil the “Powell Put”: (i) scenarios under which inflation could surprise; (ii) dataflow out of China; and (iii) the ultra-flat yield curve.
Of course, the Fed will look prescient if China slowdown becomes deeper, Europe loses momentum further, geopolitical risks spike, and US consumer confidence wanes, taking the auto and housing markets with them. But the central bank may well rue such foresight, as that would be accompanied by calls for reversal of quantitative tightening and rate cuts, which it is not quite considering for this year. In its attempt to soothe asset market sentiments, the Fed may have over-corrected and brought into play dynamics that it is not keen to contemplate, in our view.
Highlights of the week:
• China: PMI highlights need for further policy support
• Singapore: Singapore Budget 2019 – More room for expansion
• Public spending to support growth
• Singapore: Singapore Budget 2019 – Sustained support for firm level restructuring
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