Daily Macro: Fed Policy Credibility: Markets and President Trump Pile on the Pressure and more

In this briefing:

1. Fed Policy Credibility: Markets and President Trump Pile on the Pressure
2. Seismic Shift in Fed’s View Driven by Anaemic M2, Implying US$-Weakness and an EM-Positive Year
3. UK Politics: Swerve, Crash or Stop (55:30:15)
4. A Golden Future?
5. India: 2018 Outlook – Strong Growth but Growing Risk of Policy Mistake

1. Fed Policy Credibility: Markets and President Trump Pile on the Pressure

Financial markets and President Trump have raised the ante on Fed policy conduct, but the clash with the Administration was inevitable given the tighter monetary policy offset to last year’s easing of fiscal policy.

President Trump’s attack on the Fed may indicate broader issues and concerns about the performance of his economic team, notably Treasury Secretary Mnuchin.

Uncertainty about the Administration’s future relations with both the Fed and House of Representatives will remain elevated during 2019, thereby increasing the pressure on the Federal Open Market Committee (FOMC) to assume a greater leadership role in the realm of economic management.

Financial markets have become excessively reliant on crystal-clear guidance from the FOMC since the financial crisis, but policy communication in 2019 will be reset to incorporate flexibility and patience in the realm of future conduct.

US equities have other adverse factors to consider in 2019 apart from Fed policy, but lower valuations suggest reduced investor complacency, as well as offering some downside protection.

Recession risks in the US are still manageable due to low inflation and the FOMC’s ability to lower the federal funds due to its past policy actions.

2. Seismic Shift in Fed’s View Driven by Anaemic M2, Implying US$-Weakness and an EM-Positive Year

Fed chairman Jay Powell’s extraordinary flip-flops over the past 3 months have left his communication strategy in tatters (unsurprising, given that he has no economics training, as we warned at his appointment: Trump Now Has a Clear Path to Damage the Fed, Even as He Loses Political Ground). Nothing in the US growth numbers or core inflation could justify the seismic shifts in the Fed chair’s language. However, M2 money supply moderated sharply to 3.8% YoY growth in October, and didn’t materially improve in November or December, suggesting that the money multiplier is not rebounding quickly enough to offset the sharp contraction in the monetary base. In our view, this is the indicator that the FOMC and market need to pay more attention to in 2019.  

While the stock market has predicted “nine of the last five recessions” (to use Paul Samuelson’s famous phrase), an inverted UST yield curve (specifically a negative 2-10 year Treasury spread) has predicted each of the last seven recessions. The 1980 recession began 18 months after the yield curve first inverted, but the lag has been shorter (about 12 months) for the subsequent four recessions. The yield curve has not yet inverted, but is inexorably trending toward negative territory. We expect the US to enter recession no later than mid-2020, bang in the middle of the next US presidential election cycle.  

A weak US$ is likely to remain the last reflationary factor for the US in 2019. But, like in 2017, US$-weakness will be positive for Emerging Markets (EMs). We expect China’s debt and growth challenges to come to a head this year, but they would have imploded a lot sooner and more drastically had this been another year of US$ strength. 

3. UK Politics: Swerve, Crash or Stop (55:30:15)

• The UK parliament continues to show its opposition to everything, including a no deal Brexit. Recent amendments are more signalling than substance, though.
• A political swerve to approve a deal based on the existing one remains the most likely scenario, in my view (55%). Brinkmanship leaves a crash out with no deal as a significant risk (30%), though, as it is the default outcome despite opposition.
• Stopping the exit from the single market and customs union (15%) is appealing to many commentators, but it still looks more like hope over reality, in my view.

4. A Golden Future?

The ability to have stable prices has great value.

According to Edward Gibbon, the decaying Roman Empire exhibited five hallmarks: 1) concern with displaying affluence instead of building wealth; 2) obsession with sex; 3) freakish and sensationalistic art; 4) widening disparity between the rich and the poor; and 5) increased demand to live off the state. Most DMs and many EMs display similar symptoms today because fiscal and monetary policies, the foundation of both ancient and modern societies, are identical: increasing welfare outlays by artificially inflating the money supply. The Roman Empire took more than four centuries to destroy what the Republic had built in the previous five centuries because clipping and debasing coins inflated currency supplies slowly. Entering debits and credits in the books of commercial and central banks is much more efficient. 

5. India: 2018 Outlook – Strong Growth but Growing Risk of Policy Mistake

The Indian economy is in a sweet spot currently. On one hand economic growth is strong and on the other hand, some of the risks have abated due to the sharp fall in Oil prices. Economic growth will thus be strong in 2019 with macro stability. However, given that 2019 is an election year, the risks of a policy mistake are high due to the divergence in economic growth between rural India and the rest of the country. It is very likely that the next few months will see some monetary easing on one hand due to the relatively benign outlook for headline inflation and fiscal stimulus on the other to prop up the rural economy. This given the backdrop of already strong overall growth and stubbornly high core inflation risks over stimulating the economy and consequent build-up of inflationary pressures – something akin to what happened in 2009 but on a smaller scale. However, that is a problem for 2020 or perhaps beyond. In the interim, 2019 promises to be a reasonably strong year with 7% plus growth, lower interest rates and strong growth in corporate earnings.