06.24.19

Fed to markets: “We got your back”

Brian Nick

The last week’s market highlights:

Quote of the week:

“An ounce of prevention is worth a pound of cure.”– Benjamin Franklin (and Fed Chair Jerome Powell at his June 19 press conference)
 
Each week, we present our featured topics in the context of the major themes listed below from Nuveen’s 2Q 2019 Outlook :
 
  • U.S. economy: Late cycle but no recession
  • Global economy: Still looking for a bottom    
  • Policy watch: Easy monetary policy to offset restrictive trade policy  
  • Fixed income: Volatile interest rates but no breakout in either direction 
  • Equities: Get defensive, stay invested 
  • Asset allocation: No longer “risk on,” but still prefer emerging-market bonds  

Policy watch: The Fed has it both ways…for now    

A lot has changed since the Fed’s May 1 meeting. Shortly thereafter, President Donald Trump announced that trade talks between the U.S. and China had broken down, triggering higher taxes on Chinese imports. Naturally, China retaliated with tariffs on U.S. goods. Moreover, global growth, which had already begun to show signs of weakening earlier in the second quarter, softened further. In the U.S., the pace of job creation has slowed, capped by May’s particularly weak employment report. Real personal spending has slumped, too, and manufacturing activity has decelerated.
China has also hit economic headwinds. Last month, industrial production fell to its lowest level since 2002, and imports plunged, reflecting subdued demand. The Chinese central bank has fired up fresh stimulus to help the economy meet the government’s GDP target of 6%-6.5%—although either number would represent the slowest growth in more than 25 years. 
 
Against that backdrop, the Fed headed into last week’s meeting with two options: push back against markets clamoring for lower interest rates or adopt a more dovish posture to instill confidence among businesses and investors. By keeping its target fed funds rate unchanged while signaling that it hears and shares the markets’ concerns, the Fed seemingly did both.
 
In its accompanying policy statement, the Fed cited increased “uncertainties” about its economic outlook—presumably fueled by trade risks and slowing global growth. The Fed also stated that U.S. economic growth had downshifted from “solid” to “moderate.” And in a nod to policy doves, the Fed removed its reference to being “patient” in determining changes to interest-rate policy.
 
Markets have priced in three to four rate reductions over the balance of 2019, starting in July, with more to come in 2020. This represents a huge shift since May, when the market-implied probability of a rate cut this year was merely a toss-up.
 
The dovish pivot notwithstanding, we don’t believe the Fed is planning to ease as much as markets currently expect. This could presage a bumpy ride for investors, who are banking on lots of help from easier monetary policy. Overall, we don’t anticipate more than one or two cuts by year end unless the U.S./China trade war escalates or the labor market weakens significantly.

Policy watch: The ECB delivers a double dose of dovishness    

Although the Fed meeting was last week’s main event, central bank watchers enjoyed a twin bill.  
 
Speaking at the European Central Bank’s (ECB) annual symposium, ECB President Mario Draghi floated the possibility of introducing additional easing measures should economic conditions in the eurozone fail to improve. Inflation, for example, remains well below the ECB’s target of about 2%, and inflation expectations have fallen to multiyear lows. GDP, meanwhile, grew just 0.4% quarter-on-quarter in the first three months of 2019. Estimates for second-quarter GDP are even worse—around 0.2%. Optimism surveys, meanwhile, have conveyed little hope of an economic rebound. In June, the ZEW Indicator of Economic Sentiment for the Euro Area fell to a near seven-year low, approaching levels plumbed during the eurozone debt crisis.
 
So what might Draghi pull from his policy toolkit before his term ends in October?
 
  • Cut the ECB’s deposit facility rate, currently set at a record-low -0.4%. (This is the interest rate that banks receive for depositing funds with the ECB overnight.) 
  • Restart quantitative easing (or bond buying), which the ECB ended in December 2018.
  • “Talk down” the euro through dovish forward guidance.
 
Eurozone government bonds rallied in the wake of Draghi’s willingness to ramp up stimulus. (Bond yields and prices move in opposite directions.) The yield on Germany’s 10-year bund fell to an all-time low of -0.32% on June 18. Also on that day, the yield on Spanish 10-year bonds dipped below 0.5% for the first time ever, and French 10-year debt joined the “negative yielding club,” which now totals $12.5 trillion worldwide.
 
In contrast to these rising bond prices, the euro weakened to just under 1.12 versus the U.S. dollar on June 18, before rebounding strongly after the Fed meeting. The common currency’s short-lived downward move drew the ire of President Donald Trump, who accused the ECB of manipulating its currency “for years.” Draghi’s response? “We can’t target the exchange rate.”
 
While that may be true, the euro’s behavior figures highly in the minds of ECB policymakers. A weaker currency would both boost inflation (a plus for the eurozone’s sluggish economy) and aid the region’s exporters by making their goods and services more competitive in overseas markets. But a look back over the past four years, for example, to the start of the ECB’s quantitative easing program, shows that the currency pair has changed very little on net. The euro closed at $1.134 on June 22, 2015—almost precisely where it ended last week.   
This material is prepared by and represents the views of Brian Nick, and does not necessarily represent the views of Nuveen LLC, its affiliates or other Nuveen staff.
 
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