Keep your eyes on the Fed
|Perhaps it’s the summer heat is making our focus hazy. In light of the severe heatwave, like a baseball pitcher, we need to approach the markets with a narrow external focus. We have our sights set on FOMC meeting on July 31st. As this is the only thing that matters in our view. Chair Powell has signaled that monetary policy easing will be coming. For anyone following markets in the last 12 years, this means price reaction. Why waste our limited energy on President Trump criticism of the Fed's monetary policy (and weaker dollar demand), news that the US shot down an Iranian drone in the Middle East, doubts about how much (or little) progress is being made in US/Chinese trade talks, and a broader lack of 1st tier economic data. What matters now is the Feds policy path. The consensus is for a 25bp cut, yet many are arguing for a larger insurance cut (analysts have dusted off the adage “shock & awe”) and Fed fund futures are implying around 30bp.
The June FOMC meeting minutes indicate that 14 of the 17 members viewed meaningful risks to growth and inflation outlook. Interestingly, the assessment of risk was based less on internal conditions such as labor and US consumer but external factors like trade. The minutes stated “recent weak indicators for business confidence, business spending and manufacturing activity; trade developments; and signs of slowing global economic growth”. Yet the size and timing for the insurance cut which this is actively being debated. There is a feeling that the Fed has been caught in the trade war hype rather than the reality of the situation. Chair Powell in recent remarks in Paris indicate worries of trade developments and global growth. The second derivative of Fed policy mandate to say the least. Trade tensions have slowed global growth with the risks to the downside. However, after two years of apocalyptic headlines, one would expect weaker reads in trade and manufacturing. But the reality is commerce continues despite Trump's disruptive trade policy by tweet.
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The US economic data continues to perform on the strong side, led by the solid labor market reads and an uptick in inflation. Even consumer spending remains high judging from healthy retail sales figures. A deep statement-making 50bp cut is a bit old fashioned in our view. The markets might want drama but we still see central banks not wanting to become the primary driver of asset pricing. For the Fed to come out with both guns blazing, with questionable data support, would be stating central bank now backstop any economic threat. If asset prices are bubbling now, then the official absolution of risk premia will send valuations into ridiculous levels. 50bp cut might front-run the risk of an economic downturn, while 25bp more of a cosmetics tweak, it’s a safer strategy within the current uncertain backdrop. A dovish 25bp cut will be enough to keep risk appetite elevated for the rest of the summer.
With so much at stake, why make markets more complicated than they need to be.
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