Keeping policy easy like Sunday morning
- Tiago Figueiredo
- Feb 10, 2020
- 8 min read
Summary
Global update — China & Europe under performing.
Fed policy — Disinflation risk from a stronger US dollar.
Fiscal policy — How long will it take?
The week ahead — Virus infects Fed communication.
Despite markets moving higher, market participants remain concerned about the global outlook.
Equity markets were anywhere from 2-4 percent higher on the week, while bond yields drifted higher anywhere from 5-10 bps. Yield curves were steeper throughout the week, driven by long-end rates as incoming economic data in the US came in stronger than expected. The move higher in equities likely resulted from an unwind in some of the market crash protection as a result of headlines surrounding a vaccine and Pete Buttigieg's surprise performance in Iowa. Apart from that, Charlie McElligott, a Nomura cross-asset strategist, highlighted that the collapse of the short-volatility fund (XIV) had fallen out of the 2-year look back window. That means that any funds that use a 2-year window to estimate volatility for their funds would now have a lower volatility estimate and could result in more buying in stocks going forward. Meanwhile, economic data has created a clear divergence between the US and the rest of the world.
The CoronaVirus continues to spread in China, prolonging any recovery in the region.
The Wuhan virus has now surpassed the death toll from SARS.
Over the weekend, we had some grim news that the death toll from the CoronaVirus has surpassed 900 people. Many companies are cautious about reopening plants and factories in China. A whole slew of car companies have announced that their factories will remain closed for another week. Fitch, a rating agency, announced that they had lowered their forecast to 3 percent growth for Q1 from 6 percent. That is in line with many other banks. The most notable revision was from JPM, who highlighted that the worst-case scenario is 1-percent growth in China for Q1. With little data for market participants to trade on, rumors surfaced that China was combining trade data for January with February to mask some terrible numbers. Although true, the real reason is likely due to the Chinese New Year, which often results in some data being shuffled. Despite the worries, the CSI 300 index finished the week down only 2.5 percent, recovering nearly 5 percent following its open last Monday. The tone in Asia is positive following the announcement that China had pledged US$ 10 billion to combat the outbreak.
China's slowing economy continues to hamper growth in the Eurozone, prompting further calls for fiscal stimulus.
A hattrick of disappointing data continues to underscore the extent to which Europe remains beset in a deep manufacturing recession.
Germany remains the poster child for the European slowdown, posting truly egregious misses on both industrial production and factory orders last week. Retail sales for the bloc also came in well below expectations, complimenting the poor showing from French and Italian GDP last week. Although December data showed some signs that manufacturing was starting to gain its footing, the hard reality is that Europe needs stronger global growth to bolster a robust recovery. At this point, it has become clear that the sheer impact of China's slowdown will be enough to prolong any improvement in the bloc. The outlook for Europe looks bleak, especially if you toss in the spread of the CoronaVirus, and the threat that President Trump brings down the tariff hammer. Analysts are beginning to revise their estimates for German growth in Q4, with some expecting the economy to contract.
Christine Lagarde, the head of the European Central Bank (ECB), continues to plead for fiscal spending.
Despite the dire outlook, the bug in European manufacturing has not made its way over to the services sector. Indeed, that may be the only thing German officials can use in favor of keeping their checkbook sealed. That's not to justify the stubbornness of German officials. Germany is a manufacturing centric economy which is refusing to provide support despite interest rates being negative. At this point, it will likely take a recession to prompt officials to take advantage of the free money that the ECB has put on offer. I wouldn't be surprised if the "bad news is good news" motto starts to take hold of markets as a further deterioration of the economy would hopefully result in some fiscal spending. On Thursday, the ECB's Christine Lagarde reiterated to members of the European parliament that lower interest rates and low inflation have reduced the scope for monetary policy going forward.
Sinn Fien, a left-wing Irish nationalist party, surged in polls on Saturday, leaving it tied with Prime Minister Leo Varadkar's party.
Although analysts expect Varadkar's party to merge with center-right rival Fianna Fial, the surge in the polls highlights the unrest within Ireland. Sinn Fien will likely not be able to form a party this year, but their ability to do so in the future will likely grow if political unrest continues. The party has been rebranded but is tainted with historical ties to the Irish Republican Army (IRA). The fear is that the boost in the polls will result in a growing demand for Irish reunification. All of this poses a real risk to the UK, especially considering Brexit has already invoked calls for a new vote on Scotland's independence.
The US economy looks set to outperform the rest of the world, likely forcing the Fed to prepare for another wave of accommodation.
Biden is in a bear market, and America is serious about Pete Buttigieg.
Following what can only be described as a complete cluster **** for the Democratic Party of Iowa, it appears that America remains serious about Buttigieg. Of course, Iowa is just the first Caucus and, in the grand scheme of things, means very little apart from a pat on the back for Pete. The big event will be on Super Tuesday on March 3rd. The chart below shows odds from PredictIt.org. Interestingly, Micheal Bloomberg has been gaining in polls despite not participating in any debates. Rumors have it that he is ramping up for Super Tuesday. Meanwhile, Biden got slammed this week following the Iowa Caucus. As I mentioned last week, I think markets continue to underprice the probability of Bernie winning the nomination.
It was a good week for the US economy.
The US economy added 225 thousand jobs in January, well above expectations and reinforcing the notion that the US remains the cleanest dirty shirt in the world economy. Hourly wages increase marginally, keeping any threat of inflation at bay. The Friday job numbers complemented the strong ADP job report, posting the best figure since May 2015. The latest manufacturing print from the Institute of Supply Management (ISM) printed in positive territory for the first time since July of last year. Apart from coming in well above expectations, the ISM print also helped ease doubts cast over the manufacturing sector from last week's Chicago PMI. Fed nowcasting models now put US growth just above 1.5 percent for the next quarter. For what its worth, Goldman estimates that the CoronaVirus will have a manageable impact of around 0.4 percent on growth but who knows for sure. The situation with the CoronaVirus remains fluid.
The CoronaVirus infects the Fed's monetary policy report (MPR) and raises questions surrounding the Fed's reaction function.
Although references to the outbreak were few, and the language subtle, the Fed did flag the risk that the CoronaVirus could disrupt global growth. When taken at face value, that isn't much news. What is important is how the virus impacts the Fed's reaction function, which, given its inclusion in the MPR, we have confirmation that it will. There are many ways through which the virus can impact US growth. The main transmission channel is through Europe and China, where the virus knocks production offline, and global demand falls.
A stronger US dollar will tighten global financial conditions.
Given that the US is generally in a good place, economically speaking, the economic impact of the virus will disproportionately impact Europe and China relative to the US. That would likely result in the US outperforming the rest of the world. If that happens, the US dollar will likely remain stubbornly strong, cheapening imports and lowering overall price pressures in the US. Indeed, we already see that. The US dollar index (DXY) has broken out to levels seen in October of last year. A stronger greenback is generally bad for global growth because it tightens financial conditions. That alone could be enough to make a case for the Fed to continue to lower rates. The chart below shows the US dollar index (DXY).
A flatter Phillips curve weakens the impact of above-trend growth on inflation.
What makes matters worse is the lack of domestic price pressures within the US. That's on account of various structural issues but, the most notable one is the flattening of the Phillips curve. The Phillips curve tells us that wages should increase as unemployment falls. That's a function of a tighter labor market, where workers gain more bargaining power. In the data, that relationship has gotten weaker over time and has contributed to weaker price pressures within the US. Without getting too much into economic doublespeak, the basic idea is that above-trend growth in the US, resulting from record low unemployment, will not create enough price pressures to offset any disinflationary pressures from imports as a result of stronger US dollar. That creates a compelling case for the Fed to lower interest rates further. Markets continue to price in around an 85 percent chance of at least one interest rate cut this year. The chart below shows a scatter plot of the relationship between wages and unemployment.
Emerging markets remain vulnerable as uncertainty surrounding global demand puts pressure on commodities and broader risk sentiment.
Emerging markets are feeling the pain from the gut punch the CoronaVirus gave the global growth narrative.
Until we understand the impact of the epidemic, emerging markets will likely remain under pressure. Central banks have been providing accommodation to help alleviate the stress from falling commodities but are now grappling with currency depreciation as a result of a broad strengthening of the greenback. The Turkish Lira was one of the casualties last week where state lenders blew through nearly US$ 4 billion to try and prop up the currency. Investors remain skittish and will not need much to start taking risk off the table.
Fiscal policy remains the only real solution to sustainable global growth.
The central bank ammo problem is back.
The big question going forward is, how weird do policymakers want things to get? After delivering one of the most significant central bank easing impulses since the Great Financial Crisis, the global economy, which was set to inflect, has been upended by a mysterious respiratory virus that crawled out of a wet market in Wuhan. If policymakers decide to provide more stimulus, they run the risk of pushing rates deeper into negative territory and drive financial asset prices higher. If they don't, they run the risk of a global recession, which will eventually force them to lower rates anyways. It's a bit of a damned if you do damned if you don't. Things are made ostensibly worse by the fact that the net supply of sovereign debt is set to fall this year. That means that any asset purchasing program has the potential to create outsized moves in interest rate products, fostering even further search for yield. At this point, it feels as though monetary policy is just digging itself a deeper hole, ultimately ending in secular stagnation or, as the Europeans are calling it, Japanification.
The week ahead
Fed Chair Powell will testify before the House and Senate this week.
The virus will likely be a topic of conversation during Powell's hearing. Ultimately, the virus reinforces the view that I highlighted in my first post this year, where I talked about how interest rate policy remains skewed to the downside. Inflation will be the key catalyst for any upside in interest rates, and we will get an update on inflation in the US this week. In Europe, all eyes will be on the German GDP numbers, which are now expected to show some form of contraction. Chinese inflation data came in higher than expected on Sunday night, and we will also be getting industrial production numbers. Central banks in Mexico and New Zealand are on the docket; both are expected to keep rates unchanged. Dealers are going into the week slightly long gamma, but that can flip fairly quickly should news flow surrounding the virus continue to come in negative. The chart below shows the gamma schedule as of Sunday night.
Tiago Figueiredo
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