Weekly: Global economy gets a helping hand from the Fed and China
- The Fed cemented its dovish tilt this week
- We are reading a signal with major implication from the Fed…
- …over the near term it may well take a relaxed view about inflation
- This could cause the yield curve to bull steepen eventually
The sharp rebound seen in asset markets got another boost this week as the US FOMC cemented its dovish tilt. The US central bank has gone through a dramatic change of heart in about three months, which has been received exuberantly by global financial markets.
Financial conditions are back to where they were during the exuberant days of Aug/Sept last year, thanks to yield compression and surge in equities. Indeed, for the US, conditions are near the peak observed in history. For China, conditions have not gone back to their peak, but have improved sharply in recent months.
Conventional wisdom in the markets used to be “don’t fight the Fed.” However, over the past decade or so, the US central bank has repeatedly scaled back its expectation of growth and inflation, and displayed acute sensitivity to the performance of asset markets. Perhaps the Fed now believes “don’t fight the markets.”
The March 20 FOMC decision reveals a bit more dovish view of the growth and inflation outlook, but they are not that material. After all, the economic projections are only 0.2% lower (2.1% vs 2.3% made in December) and even more modest for inflation (1.8% vs 1.9%). But between the line, we are picking up a more profound signal—which is that despite strong wage growth and rebounding commodity prices, the Fed will take a relaxed attitude if inflation were to pick up again. If true, this would mark a major departure in the monetary policy stance. We think that Fed communication will be increasingly focused on this area; having undershot its inflation target year after year, a bit of overshoot will be overlooked by the Fed in 2019 and 2020.
In our rates section, we consider the implication of this line of signaling. Right now, the fixed income market is rallying, but could the long-end eventually sell off as inflation bottoms, fiscal deficit remains large, and demand for long duration assets wane? We think this is quite possible, and not at all priced by the market.
Fed’s dovish move extends beyond dot plots. Strikingly, the Fed has made clear that the pace of balance sheet normalisation will be slowed. The cap in monthly redemptions of treasury holdings will go to USD15bn beginning in May (from USD30bn). This and other tweaks will leave the Fed balance sheet steady at around USD3.5trln later this year.
These measures are going to provide crucial support to emerging markets, in our view. Liquidity conditions and cost of financing, both of which were sources of major headwind last year for EM rates and credit, will fade. But the eventual steepening of the US yield curve that we are envisaging could complicate the long-term funding picture eventually.
These market pleasing developments have fueled rallies in EM assets already, but how sustainable is that? We note that both China and Europe have several idiosyncratic headwinds in play, which form negatives for their markets and economies. For China, these include the negative spill-over from its debt overhang and weak domestic sentiments. For Europe, they range from Brexit to complicated politics in France, Germany, Italy, and Spain. Hence, we are not expecting a sharp selloff in DXY.
We feel that Western central banks still do not fully appreciate the impact of China on their growth and inflation outlook. Perhaps the reaction function of policy makers should give higher weight to China’s demand and price conditions, as they seem to be the best early warning indicators of the global cycle. With that mind, If the ongoing fiscal stimulus in China and positive developments in the China-US trade talks stabilise global demand and sentiments, the Fed may come across as having blinked too early.
Impact of China stimulus
Real economic data out of China remain poor, ranging from trade to PMI. Meanwhile, debt metrics keep worsening and sentiments are weak. But at the same time, expectations of largescale support for consumption (through incentives for purchasing white goods), firms (tax cuts), liquidity (through monetary easing), and investment (infrastructure spending) have risen. Combine this with the view that a China-US trade deal is around the corner, it is understandable why the market is ignoring the subdued data and looking forward instead.
A dash of realism may well be in the pipeline; trade negotiations can hit roadblocks, and stimulus measures can fail to achieve the desired results. Until that scenario transpires, global markets are taking a positive cue from China. Commodities have made a smart comeback this year, with oil up nearly 20%. This would help diffuse some of the fears of deflationary forces. Global shipping indices, which had nosedived late last year, have stabilised as well.
It is far too early to suggest that the Fed’s dovish tilt and the China stimulus will create global reflation, but we are convinced that the authorities in China and the US are on the right track with their approaches. Some inflation and a resulting bull steepening could do this debt-laden world a lot of good.
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