Posted on: 10 Jul, 2019
If Powell goes off the script, it will certainly represent a better prospect to trade around wilder volatility but one highly doubtful he is ready to commit to judging by all the factors exposed in the following article.
To our Market Insights
Fed Chair Powell is due to testify on the Semiannual Monetary Policy Report before the House Financial Services Committee and the world of finance is watching as the ramifications it could have on market volatility are considerable. Everyone and their dog awaits for Powell to clarify the guidance on the Fed's easing path.
Powell will give his testimony at 10 a.m. local time in Washington this Wednesday, the same day the central bank is scheduled to release the minutes of its last policy meeting hours later. On Thursday, Powell will testify again in front of the Senate banking panel. Lawmakers await with pressing questions that will range from issues such as the Fed’s independence amid Trump’s attacks, economic activity, Facebook’s crypto plans, a framework of the Fed's one-year projected interest-rate path, etc.
Will Powell further cement the notion that the codeword given in the last FOMC “an ounce of prevention is worth a pound of cure” is indeed what the market interpreted as an immediate insurance cut? The rationale for the Fed appears to be justified on the basis of US trade policy uncertainties, the slowdown in global growth, and risks of lower US economic activity. In the case Powell sounds ambiguous and non-committal, in my opinion, will be an admission that his intended course (July cut) of action is undeterred.
If we look at the CME Fedwatch tool, with chances of a 25bp rate cut at 96.2%, it’s essentially baked in the cake in the eyes of Mr. Market. What's clearly created some extra buzz around economists' opinions on whether or not Powell will stick to his guns with a July cut is the stellar US NFP (+224k) or the S&P 500 trading at record highs.
Let’s decode all the information we have at our disposal to make a rational assessment. First of all, let’s be clear. Central Banks like to use fancy and often twisted terms to telegraph their intentions. So when last June 19th Powell said “an ounce of prevention is worth a pound of cure”, the market picked up on the hint that rates are coming lower, since the literal translation is that a little precaution before a crisis occurs is preferable to a lot of fixing up afterward. In Central Bank semantics, this means all day that the ground is being laid for easing.
It’s important to also bring to the surface what the Fed has obviously tried to subtly camouflaged under its dual mandate. I am referring to the clear shift in directive from being the ultimate guardian of maximizing employment and stabilizing prices to now being a prisoner of financial conditions. The cruel reality is that equity markets have been broadly sustained and FX volatility fairly depressed because Mr. Market counts on a new cycle of easing around the corner.
Sadly, this puts Powell in an awkward position as any admissions during this week’s testimony that may lead the market to second guess Powell backtracking on his intention to ease in July, that alone, will with almost all certainty take financial markets to the woodsheds. I am talking of a much higher USD, stock annihilated and bonds too sold hard.
The commencement of an easing cycle remains the key card Powell must keep hinting to play, which is why the market finds it hard to imagine a suicidal turnaround away from anything that doesn’t imply an imminent insurance cut. One would think he’s learnt his fair share of lessons from last year’s miscommunication that forced him to activate the Fed Put to create a Fed-induced circuit breaker for stocks, alongside the relaxation in trade tensions.
But let’s look at key facts since the last FOMC as risks do exist of an upset, judging by how the Fed has characterized the justification of an easing campaign.
Note, when the last FOMC on June 19th took place, the S&P 500 was a mere 1.5% lower from the current record level, yet the Central Bank signaled, for the first time since the GFC, that the time had come to be prepared for lower rates to keep the record US economic expansion going. It clearly communicates that this time around, unless financial conditions tighten considerably, that the level in equities is not acting as the make or break catalyst should the Fed decide to slash rates in July.
As the comparison of June’s FOMC statement with the one issued on May 1 illustrates, until further clarification is provided, for the Fed it’s rationale to justify an insurance cut lies on the increased uncertainties about the outlook on economic activity, supported by the decade long depressed inflation.
What this translates into, especially on the back of a blockbuster US NFP and a trade truce aimed to temporarily provide a circuit breaker to the rapid escalation in tensions, is that Powell’s updated assessment of risks to the U.S. outlook will be a critical message to decipher as the Fed has made this the base case in its rationale if they were to cut.
If the Fed’s semi-annual monetary policy report from last Friday serves as an indication of Powell’s view, it still portends a rather cautious outlook with reiterated references made to a slowdown in global trade growth and investment intentions.
“Data for the second quarter suggest a moderation in GDP growth — despite a pickup in consumption — as the contributions from net exports and inventories reverse and the impetus from business investment wanes further,” the Fed stated in its semi- annual policy report.
“Trade policy developments appear to have lowered trade flows to some extent, while uncertainty surrounding trade policy may be weighing on investment,” the report added.
While the stellar payroll gains in June may relieve some pressure to cut, the devoid of inflationary pressure in annual wage gains does somehow offset one another. Therefore, this leaves us back to square one with a Fed still potentially seeing the case to go ahead with the insurance cut.
On the ceasefire in the US-China trade war, skepticism is still the name of the game, as the two sides still remain worlds apart on the most pressing issues such as technological transfers, IP rights, and accountability mechanisms. In my view, the weak Yuan tells me trade tensions between the two powerhouses creeping up are set to return.
Also remember, since existing tariffs on Chinese imports were not removed and Huawei is still facing restrictions, the negative impact due to trade-related shocks and investment will still weight in potentially debilitating the economy by disrupting supply chains, higher production costs, which ends up lowering the profit margins of businesses. The Fed sure must be accounting on these risks going forward as it can ultimately feed through the economy by lowering job opportunities.
So, we are starting to deconstruct that the Fed’s risk assessment has not deviated from the last FOMC meeting in June, as it keeps outlining rising risks of an economic slowdown, while steps to assure the continuation of the expansion are also sure to be taken should they be needed.
Even if in terms of timing the first 25bp rate cuts, the Fed is now better positioned to justify waiting at least until September as further evidence can be gathered on trade-related demand shocks and the overall economy, it’s a dangerous gamble for Powell if the can is kicked down the road.
Powell should have learnt from his ‘Fed Put’ days not to swim upstream against the market current (pricing). This time, a delay in the rate cut, while leading to a violent mark-to-market repricing, what's most concerning is the confidence from businesses in investment intentions or housing, that is at stake, especially in a late economic cycle.
What the strong US NFP certainly helped with is to evaporate the chances of a 50bp July rate cut. Here, not only logic defies such a move, but the market agrees, as the odds is now under 5%. The fact that perma dovish St Louis Fed President Bullard made the suggestion that such an aggressive action “would be overdone”, does speak loud and clear that it does look unrealistic.
To sum up, the Fed, one thinks, still enjoys ample room to adjust its policy. Because of that, the precautionary July rate cut, as the lay of the land stands when taking all the factors into consideration, including the not so subtle aspect of not fighting the market, is still a pragmatic approach that should remain the base case. If Powell goes off the script, it will certainly represent a better prospect for volatility but one I doubt he is ready to commit to judging by all that I've exposed above.
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