Fed Chairman Powell testified before the Senate today and the House tomorrow. Not much has changed since the January 30 FOMC meeting and so Powell basically hewed to the Fed’s recent script of stressing “patience” and “flexibility.” We remain bullish on equities and the dollar and bearish on bonds.
There is another full slate of Fed speakers this week, but the main event will be Powell’s semi-annual Humphrey-Hawkins testimony before the Senate today and the House Wednesday. Bostic (non-voter), Harker (non-voter), Kaplan (non-voter), Mester (non-voter), and Powell (voter) speak Thursday, followed by Bostic on Friday.
In his prepared remarks, Powell noted that the US economic outlook remains favorable. He did acknowledge the negative impact of the shutdown as well as other “cross-currents” but was otherwise upbeat. In the Q&A section, Powell noted the labor market remains strong and that wages are moving higher. He added that there is more slack in the labor market as people re-enter the workforce.
Powell did acknowledge that the US is on an unsustainable fiscal trajectory, adding that failure to raise the debt ceiling creates uncertainty. He noted that China and Brexit are major risks to the economic outlook, and that slower global growth has turned into a headwind for the US. Powell added that foreign risks are particularly relevant now.
Powell did not bring any clarity to the balance sheet issue. All Powell basically said today was that discussions are ongoing, and that the Fed’s balance sheet will remain larger than pre-crisis levels. We note that the Fed’s balance sheet currently stands at $3.98 trln. While this is the first sub-$4 trln reading since December 2013, the balance sheet remains well above pre-crisis levels near $875 bln. That’s a lot of wiggle room in between these two levels.
The next FOMC meeting is March 20 and a pause then is a foregone conclusion. New staff forecasts and Dot Plots will be released then. Hopefully, we will also get some more clarity on the balance sheet issue. Ahead of that, the market will get one more US job reports to digest as well as a little over a week of Fed speakers spreading the new gospel according to Powell. The Fed’s media embargo will begin after March 6, when the Fed releases its Beige Book report.
What’s changed since the January 30 FOMC meeting? The US data have come in mixed. Two days after the FOMC meeting, the US reported a whopping 304k gain in nonfarm payrolls for January. That same day, January ISM manufacturing came in at 56.6 vs. 54.0 expected.
However, these strong readings were followed by a much weaker than expected December retail sales report. Headline sales plunged -1.2% m/m, ex-autos by -1.8% m/m, and the so-called control group by -1.7% m/m. These readings were such outliers that we cannot help but assume that they will be revised upward with the January report due out sometime between March 11-15.
We still believe the Fed gave in too quickly and too completely to market demands that it pay more attention to market movements. By doing so, the Fed changed its message by a whopping 180 degrees from the December meeting and reinforces our complaints about the extreme swings in Fed messaging over the last few months. It’s clear from recent comments that the Fed is making extra efforts to address this complaint.
A BRIEF HISTORY LESSON
The Employment Act of 1946 was passed in an effort to make sure that workers were not left behind as the US shifted from a wartime to a peacetime economy. In particular, policymakers were concerned about absorbing the hundreds of thousands of soldiers returning home from WWII. The Employment Act stated that the goal of the government was to create “conditions under which there will be afforded useful employment for those able, willing, and seeking work, and to promote maximum employment, production, and purchasing power.” The Employment Act also created the Council of Economic Advisers (CEA), a three-member board that would advise the president on economic policy.
Fast forward, to 1976, when a period of stagflation led Senator Hubert Humphrey to introduce legislation that would set explicit employment goals. If those goals were not met, the government would have to provide more jobs to meet them. Humphrey also wanted to give the executive branch more control over monetary policy. In 1977, the Federal Reserve Act was amended to have the Fed pursue the goals of stable prices and maximum employment.
Senator Humphrey and Representative Augustus Hawkins (his colleague in the House) continued to push forward and in 1978, Congress passed the Full Employment and Balanced Growth Act. Otherwise known as the Humphrey-Hawkins Act, it amended the Employment Act of 1946 to set several new goals for unemployment and inflation. However, it’s worth noting that the final version turned out to be much less interventionist than the initial proposal. The Fed would have to explain its policies in greater detail, but there would be no interference from either the executive or legislative branches.
The Humphrey-Hawkins Act thus required the Board of Governors of the Fed to deliver its Monetary Report to Congress twice a year, in February and July. At the same time the Fed Chairman is required to testify before the Senate Committee on Banking, Housing, and Urban Affairs and then the House Committee on Financial Services. That is why Chairman Powell is appearing before Congress this week.
We have the first piece of the February jobs puzzle in place. Weekly initial jobless claims number for the survey week (the one that includes the 12th of the month) fell to 216k. This is the lowest reading since the week of January 18 (last month’s survey week), which came in at 200k. We all know how the January jobs report went.
The Job Openings and Labor Turnover Survey (JOLTS) is one of those numbers that often flies under the radar. It rose to an all-time high of 7.335 mln in December. From BLS: “The number of unfilled jobs—used to calculate the job openings rate—is an important measure of the unmet demand for labor. With that statistic, it is possible to paint a more complete picture of the U.S. labor market than by looking solely at the unemployment rate, a measure of the excess supply of labor.”
Of course, none of these indicators are perfect in predicting NFP. Right now, BBG consensus for February sees a 170k gain in NFP when jobs are reported March 8. More importantly, average hourly earnings are expected to rise 0.3% m/m. If so, the y/y rate would rise to 3.4% and this would be a new cycle high. This is to be expected, as growing demand for labor suggested by JOLTS data should show up more and more in average hourly earnings. While Powell downplayed the inflation significance of higher wage growth, we think bond markets would take notice.
US Q4 GDP will be reported Thursday. Growth is seen slowing to 2.3% SAAR from 3.4% in Q3. The Atlanta Fed’s GDPNow model is now tracking 1.8% SAAR growth vs. 1.9% previously. The New York Fed’s Nowcast model is now tracking 2.3% SAAR for Q4 vs. 2.2% previously, while Q1 growth is tracking 1.2% SAAR from 1.1% previously.
More Fed regional surveys for February roll out this week. Last week, the Philly Fed survey came in at -4 vs. 14.0 expected. Dallas Fed reported Monday (13.1 vs. 4.7 expected) followed by Richmond today (16 vs. 5 expected). Kansas City Fed reports Thursday (6 expected). These are secondary to the Chicago (out Thursday and expected at 57.5) and ISM manufacturing (out Friday and expected at 55.7). However, they will all help round out a fuller picture of the US economy here in Q1.
Inflation remains subdued. January headline CPI slowed to 1.6% y/y while core CPI ticked up to 2.2% y/y. February CPI data will be reported March 12, with PPI out a day later on March 13. Note that PPI showed a similar dynamic to CPI in January, with headline slowing to 2.0% y/y and core picking up to 2.6% y/y.
By shifting its stance so dovish last month, we felt the Fed sent a clear signal to buy equities and sell the dollar. Equities have responded accordingly, with the S&P 500 up about 5.5% since January 30. Equities, which had been signaling recession risk with the December swoon, are now telling us that those risks have dissipated. We concur. We continue to downplay recession risks in 2019 and believe that US equity markets are likely to remain buoyant.
We continue to believe that markets are underestimating the Fed’s capacity to tighten this year. The Fed Funds futures strip is basically signaling steady rates in 2019 followed by growing odds of easing in early 2020. We are more upbeat on the US economy and believe that a hike this June is likely if the data remain firm in H1. Whether the Fed hikes again in December will of course depend on how the data look in H2.
The dollar has been a bit choppy as Powell testified. To his credit, he stuck to the basic Fed script and didn’t say anything surprising or off-script. So, what’s behind the dollar price action? We think it was already trading with a soft bias going into Powell’s testimony and so his “steady as she goes” message simply fed into that.
Our constructive US economic outlook and the implications for Fed interest rates leads us to remain bullish on the dollar. Indeed, beyond the initial knee-jerk reaction right after the FOMC meeting, the dollar has remained relatively firm. The initial leg of the USD rally largely reflected negative developments abroad. We believe this current dollar pullback reflects lower Brexit risks. If and when the US rates markets come around to our point of view, this should be the fuel for the next leg of the dollar rally.
DXY is still up over 1% since the FOMC despite giving back over half of those post-FOMC gains. The last major retracement objective from the January-February rise comes in near 96.0. Below that is the 200-day moving average currently near 95.626. A clean break below both of these levels would set up a test of the January 31 low near 95.162.
Despite the Fed’s volte face, the bond market is signaling greater recession risk, not less. The yield curve has continued to flatten and is moving closer to inversion. The 3-month to 10-year spread has been shown to be the most reliable indicator for a recession, and it has narrowed to 21 bp from 39 bp before the FOMC. Of the most widely watched spreads, the 1- to 10-year spread is the closest to inverting at 12 bp currently, down from 18 bp before the FOMC.
What will turn the bond market around? We think it all depends on the US data. While one data point won’t change the market’s ultra-dovish take on the Fed, February jobs data takes on even greater importance. Average hourly earnings in particular will come into focus. After that, the January retail sales will be closely watched for signs of a solid bounce-back from the weak December reading.