Fed having a deep effect despite crisis conditions nowhere to be seen

Outlook:

Today we get the usual initial jobless claims ahead of payrolls tomorrow, new home sales, and earnings from some biggies (Amazon, GE, DuPont). The Fed has sucked all of the oxygen out of the room and nobody is talking about payrolls, although we know perfectly well it's going to roil the FX and other markets, because it always does.

We see two themes today—whether the Fed abandoned traditional policy stances for a cheap immediate gain, including currying favor with the White House and basically subsidizing risk-takers, and whether the ECB follows the Fed. Draghi did not rule out a return to QE, and now we are seeing bond yields fall like a rock. We see the Bund yield down to 0.175% this morning and as reported last week, possibly headed for zero or negative again. The FT reports that now Italy is technically in recession (two quarters of negative growth), the 2-year yields has fallen to 0.243% this morning, down 4 points and nearing the lowest low from mid-May last year. And the "10-year yield is at 2.585 per cent, well below the high of 3.783 per cent which it hit during last summer's budget row but above the 2.2 per cent it had been trading at in mid-May 2018.

"The downward shift in Italian yields, which comes amid a rise in prices, has been helped by a wider dovish mood in the markets after the US Federal Reserve reversed its view of the likelihood of further rate rises on Wednesday. Eurozone government bond yields have benefited, partly "as a result of some second-guessing whether the European Central Bank may follow the US central bank in the not too-distant future", said analysts at UniCredit. This marks a reversal of investors' expectations for the path of European government bond prices this year — the end of the ECB's bond-buying stimulus programme in December was widely expected to put upward pressure on yields, particularly in the periphery."

In other words, the Fed is having a wide and deep effect. It's almost as though it is announcing a new crisis... when crisis conditions are nowhere to be seen. We can guess at them, but warning signs are not the thing itself.

Pundits persist in declining to name the US-China trade war as the proximate cause of all this, but we say it is. Other factors are supportive, like Italy's structural problems and Brexit, but the biggest factor in the eurozone slowdown may well be the loss of the Chinese export market and imaginings about how that ripples through the German and broader EU economy (ref ZEW, IFO and PMI data). Even Mr. Draghi named it last week when addressing the European Parliament, saying "China can ride to the rescue of the eurozone economy, telling MEPs that stimulus measures introduced by Beijing would ease pressure on the region's exporters." (FT) China accounts for a little over 10% of Europe's exports, up from 5-6% only a few years before and thus undoubtedly an engine of growth.

Meanwhile, the Fed is losing credibility by the minute. We are stunned. The Fed has spent countless hours working on transparency and communcations, to the point where Fed-watchers literally look at every word and punctation point. Now the Fed chief comes right out and says its broad economic outlook has not changed, but "financial conditions" (aka the stock market) point to the Fed having over-tightened, so okay, let's loosen up.

Powell speaks with forked tongue. First he says economic growth remains "solid" and the Fed expects growth to continue. But "The case for raising rates has weakened somewhat." Why? He named three factors: sluggish inflation, slowing growth in Europe and China, and the possibility of another federal government shutdown." Two of the three can be laid at Trump's feet. Powell said "My colleagues and I have one overarching goal--to sustain the economic expansion." Feeding sugar to the stock market is not the same thing as helping sustain the expansion. Any economist can tell you there are 17 other ways to sustain an expansion beyond the interest rate outlook or QT. We'd give a dollar to know what Greenspan, Yellen and Bernanke really think. Greenspan in particular refused to kowtow to the equity crowd. "Financial conditions" are not the real economy. To be fair, Powell said that to see a need for further rate increases, "a big part of that would be inflation." Some analysts take that to mean the Fed could easily resume tightening later this year. Maybe the announcements yesterday just signaled a pause, not a halt. Well, that's to disregard the immense pressure of a president who openly disparages the Fed in public and praises it for lifting the S&P when it obeys his wishes. The normally slow-as-molasses Fed reversed course in a matter of weeks this time. It can't be an accident.

Powell insists he is not making "mistakes of character or integrity," but you can't have an unchanged forecast of an expanding economy and ending tightening, not to mention loosening, at the same time. The concept of "normalization" has flown out the window. Maybe we never needed normalization in the first place, if it's a fiction invented by model-obsessed economists. But the concept of a neutral rate (also sometimes named a natural rate), while murky, is not stupid. Normalization to within a historic range of real rates is a Good Thing. On a practical level, it gives the Fed room to loosen if it really has to. On the bigger macro level, keeping conditions "extraordinary" is to interfere with free market pricing. That interference causes inefficiencies and misallocations. Those who do not learn from history are condemned to repeat it.

At a guess, the dovish-seeming Fed is going to rule the roost for weeks to come. Data won't matter unless Powell says it changes the Fed's economic outlook. Payrolls tomorrow will be seen solely in the light of how the Fed interprets them. If low, the dollar falls some more. And payrolls should be low given weather and the federal shutdown. But get out of Dodge, anyway. Spikes lie ahead.

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