99 Problems But The Fed Ain’t One

The Fed delivered an extremely dovish hold today. In doing so, we fear that the Fed has given in too much to the market and its tantrums and recent Fed messaging leaves a lot to be desired. There are still a lot of potential risks to the market ahead. As such, we see potential for further volatility and swings in market sentiment if this current round of Fed messaging turns out to be too dovish, as we suspect. For now, however, markets have the green light to buy equities and sell the dollar.

RECENT DEVELOPMENTS

The Fed left rates steady, as widely expected. However, it was an extremely dovish hold and so equity and bond markets as well as the dollar reacted accordingly. Why? To us, the big surprises were 1) the Fed removing any reference to “further gradual rate increases” and 2) the Fed saying it’s prepared to adjust its balance sheet normalization.

With regards to 1), we think removing that phrase is a mistake. Does this signal a pause? Or does it mean that the Fed is done hiking? It’s way too early to say the tightening cycle is over and officials should not paint themselves into a potential corner like this. Indeed, this was an unnecessary step beyond “patience” and “flexibility.”

With regards to 2), we are in the group that believes balance sheet runoff (QT) has been unfairly blamed for recent market turmoil. QT has been going on since October 2017. Did it suddenly cross a magical threshold where it started to impact markets? Or was the turmoil in December more from some bungled messaging from the Fed? Either way, the Fed gave the market what it wanted.

Balance sheet management took up a large part of the discussion. This was a far cry from his “auto-pilot” view last month. Powell even hinted that the Fed is getting close to the end of the runoff, noting that the ultimate size of the balance sheet will be driven by demand for reserves plus a buffer. He acknowledged that the Fed is evaluating the appropriate timing for the end of runoff, and that it will continue to be discussed in future meetings.

Bottom line: we believe the Fed gave in too quickly and too completely to market demands that it pay more attention to market tantrums. By doing so, the Fed changed its message by a whopping 180 degrees from the December meeting. This goes back to our complaints about the extreme swings in Fed messaging over the last few months. Markets would have been happy with “patience” and “flexibility” but instead, the Fed went ahead and gave away the family silver.

The next FOMC meeting is March 20. Then, new staff forecasts and Dot Plots will be released. Ahead of that, the market will get two more US job reports to digest as well as a bevy of Fed speakers that will spread the new gospel according to Powell. The Fed’s media embargo will end Friday when Kaplan (non-voter) gives the first post-FOMC speech.

 

ECONOMIC OUTLOOK

We now have two pieces of the jobs puzzle in place, both good. Weekly initial jobless claims number for the survey week (the one that includes the 12th of the month) fell to 213k. Claims then fell the next week to 199k, the lowest since 1969. ADP today reported a 213k gain in private sector jobs. Of course, these indicators are not perfect in predicting NFP. Right now, BBG consensus for Friday sees a 165k gain vs. 312k in December and average hourly earnings are seen steady at 3.2% y/y.

Bottom line: the shutdown’s impact on the jobs data should be limited. According to guidance from the BLS, federal employees who are furloughed will be counted as employed. Furthermore, those who are working but not receiving pay will also be counted as employed.

Meanwhile, the broad economy should recover from the partial shutdown and post decent growth in Q1. Advance Q4 GDP has been delayed until next week, with consensus currently seeing growth of 2.6% SAAR, down from 3.4% in Q3. Personal consumption is expected to pick up to 3.8% SAAR from 3.5% in Q3. The Atlanta Fed’s GDPNow model is currently tracking 2.7% SAAR growth for Q4, down from 2.8% previously, while the New York Fed’s Nowcast has Q4 growth at 2.6% and Q1 at 2.2%.

The IMF recently revised down its global growth outlook to 3.5% for this year. However, this was due largely to the eurozone, where the 2019 growth forecast was cut from 1.9% to 1.6%. The IMF’s US forecast was kept unchanged at 2.5% for 2019. Are there risks to the US outlook? Of course. But to tilt so much to the dovish side now is simply irresponsible.

 

INVESTMENT OUTOOK

The Fed sent a clear signal to buy equities and sell the dollar. Yet how far can this go? DXY is testing important support near 95.30. This is the last major retracement objective of the September-December rally as well as the 200-day moving average. Clean break below would set up a test of the September low near 93.81.

Much will depend on the data. While one data point won’t change the market’s ultra-dovish take on the Fed, this Friday’s jobs data takes on even greater importance. If we get a weak number, then this equity rally and dollar sell-off should intensify. If we get a strong number, we think we should see some profit-taking at the very least.

The bond outlook is not so clear, however. While the dovish Fed stance should keep short-term rates down, the long end will continue to be tested by increased issuance. At today’s quarterly refunding announcement, the Treasury announced auctions of $84 bln in long-term debt this quarter, up $1 bln from last quarter and the fifth straight quarterly increase. With the deficit expected to widen over the next several years, supply should become an increasingly important issue for investors.