Tallying the crosscurrents to the next Fed move
admin | March 1, 2019
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.
The Fed in January flagged a list of crosscurrents clouding the economic outlook and likely sidelining monetary policy until June. A month has since passed and some of the crosscurrents have started to clear. Others should clear in coming months. Only soft global growth looks likely to still cloud the picture, leaving an open question of whether weakness in Europe and China will have enough impact to steer Fed policy. Robust US momentum should be enough to counter any overseas softening.
Fed Chairman Powell has specifically referred to six items that he called crosscurrents, although a seventh probably belongs on the list. Each item can get either a green light (cleared up), yellow light (not cleared up yet but well on the way), or red light (still a problem).
- Federal government shutdown. Although the 35-day shutdown was over by January 30, the prospect of a second shutdown on February 15 remained very real. In addition, it was pretty clear that the shutdown had done damage to financial markets and to business and consumer confidence, but it was too early to get a sense of whether those negative forces would recede quickly enough. A month later, this crosscurrent is now green, as another shutdown is off the table and consumer and business sentiment surveys have generally bounced back sharply in February.
- Tighter financial conditions. While financial markets had already begun to turn around by the end of January, financial conditions remained considerably tighter than they had been for much of 2018. A month later, the S&P 500 has regained about 75% of the ground lost from the all-time high set in September and is now trading somewhat higher than the 2018 average. Risk spreads have also reversed much of their late-2018 widening. In fact, financial conditions indices have largely recovered. The Bloomberg Financial Conditions Index has retraced 182 bp of the 222 bp tightening that occurred in the fourth quarter, while the more-comprehensive Chicago Fed National Financial Conditions set a new 25-year low this week. Financial conditions go green.
- While the UK and EU seem no closer to an agreement as the March 31 deadline approaches, I would give this one a yellow label for two reasons. First, financial market action so far this year suggests that the prospect of a hard Brexit is not likely to have the same global impact that the initial vote to separate had in 2016. Second, there have been indications in recent days that the UK may be inclined to delay exiting the EU if no agreement is reached by March 31, which lowers the odds of a disruptive exit; any other scenario is likely a non-event for global financial markets and the Fed.
- Ongoing trade negotiations. This is a reference to the U.S.-China trade talks and to the very real prospect at the time of a dramatic increase in tariffs scheduled for March 1. While the long-run ramifications for the U.S. and Chinese economies to the resolution of the big structural issues at play, such as intellectual property theft, may be enormous, financial markets and the Fed primarily are concerned with the more acute short-run issue of whether we are going to have additional tariffs and, perhaps, an all-out trade war. This crosscurrent also gets a yellow because the March 1 tariff move has been postponed indefinitely and there is rising optimism that the two sides will reach a comprehensive deal. It is easy to see a path to a green signal from this crosscurrent well before the June FOMC meeting.
- Consumer confidence. Consumer confidence has definitely bounced back in February, as the Conference Board, University of Michigan, and weekly Bloomberg gauges have all reversed more than half of the December/January drop. With business sentiment, it is a little early to draw a firm conclusion. I would eagerly await the next NFIB small business sentiment reading, which will be released on March 12, as well as ISM survey results for February and March. Several of the regional manufacturing reports for February have shown sharp improvement, but it will take more data to draw solid conclusions. In sum, it appears that the dip in sentiment, especially for consumers, was primarily associated with the federal government shutdown and the swoon in financial markets and thus is in the process of quickly reversing. I am labeling this crosscurrent yellow, though as with the other yellows, it is pretty easy to see a path to full green well before the Fed re-engages in June.
- Data disruption. The Fed did not put this on the list, but it belongs. The federal government shutdown disrupted the economic data calendar, and the Census Bureau has not made much progress in February toward catching up. However, Census released an updated calendar for upcoming releases on Wednesday that includes an accelerated release cycle in March (February reports), which gets the agency more or less back on schedule by April (March reports). Given how dodgy some of the shutdown-delayed reports have been (most notably, December retail sales), this remains a significant source of uncertainty, so data delays get a yellow label for now, but this crosscurrent will dissipate with certainty by the end of April, in plenty of time for the Fed to have a timely read on the U.S. economy at the time of the June FOMC meeting.
- Weaker global growth. Powell noted that “growth has slowed in some major foreign economies, particularly China and Europe.” This gets a red light, as, if anything, the data from both Europe and China have been worse recently. Even if this crosscurrent remains red, one question that should be resolved by June is whether softness in overseas economies will have a severe impact on the U.S. economy. Given that domestic demand accounts for about 85% of U.S. GDP, the American economy can probably withstand a modest deterioration in global prospects.
For the scorekeepers, that’s 2 green, 4 yellow and 1 red. Of the yellows, one will be green with certainty within six weeks, and it appears currently that the odds are high that all of the yellows will be resolved to a sufficient degree by June that they will not play a major role in Fed decision-making once the current pause period has elapsed. That means that of Powell’s crosscurrents, probably only soft global economic conditions will still be a problem by June, and by that time, it should be much clearer whether weakness in Europe and China will have a sufficient impact on the U.S. growth rate to steer Fed policy. robust domestic momentum should be ample to counter any overseas-driven softening.
When the Fed returns to the table in June to actively consider monetary policy, the crosscurrents should have receded to gentle breezes, and whether the Fed raises rates or not will depend, as it usually does, on U.S. growth, the labor market, and inflation.
1 (646) 776-7714