The Fed plays musical chairs

Brian Nick

Article Highlights

Quote of the week

“From now on, depressions will be scientifically created.” ― Congressman Charles A. Lindbergh, Sr. (father of aviator Charles A. Lindbergh, Jr.) upon passage of the Federal Reserve Act in 1913.

The Lead Story: Could Powell be the pick?

Prior to leaving for Asia on November 3, President Trump is expected to select a nominee to replace current Federal Reserve Chair Janet Yellen, whose four-year term ends in February. The post is subject to confirmation by the U.S. Senate.

As of October 20, the candidates, in order of their likelihood of being selected are current Fed Governor Jerome Powell (60%); economist John Taylor (19%); Yellen (16%); and former Fed Governor Kevin Warsh (7%); and Yellen (13%). These percentages are according to PredictIt.com. (The numbers don’t add up to 100% because this is merely a rough form of handicapping and not a perfect market.)

If Trump picks Powell, the transition would be nearly as smooth as if Yellen herself were reappointed. And Powell’s Senate confirmation would likely be easier than Yellen’s because of Powell’s wider Republican support—a fact likely not lost on the White House.

But if Taylor, one of the more hawkish candidates, is selected, we’d expect a shaky initial response from both the stock and bond markets on the risk that he might diverge meaningfully from Yellen’s approach. That’s because changing the course of current monetary policy is tricky business. First, he’d need to forge a new consensus among the voting members. Second, he’d have to reckon with the fact that the market has internalized the relatively dovish forward guidance on rate policy and could react adversely to changes to that policy. Lastly, he’d have to consider policies currently being undertaken by other central banks.

Should the European Central Bank, for example, slow-play its exit from quantitative easing, the Fed will encounter difficulty accelerating its hiking cycle without sending the U.S. dollar back to uncomfortably high levels. Given these obstacles, markets that otherwise might have been wary of Taylor’s candidacy barely budged following reports early in the week that his interview with Trump went well. 

In U.S. fixed-income markets, the yield on the 10-year Treasury note rose nine basis points (0.09%), ending the week at 2.39%. (Yield and price move in opposite directions.) Much of the increase was attributed to news on October 20 that the Senate had adopted a budget for the next fiscal year, a key step before tackling tax reform.

Overall, Treasury market volatility has been low recently amid robust demand for U.S. fixed income and few signs of sustained inflation. History has taught us that the current trend of Treasury yields remaining rangebound while equities advance is not sustainable over time; one or the other must “give.” If the economy is indeed strong, Treasury yields should eventually rise. In contrast, if the economy is struggling, they should decline. 

Most non-Treasury fixed-income sectors also posted negative returns for the week through October 19. High-yield bonds bucked that negative trend with a modest gain.

In other news: U.S. equity investors are being actively passive

The S&P 500 Index rose 0.9% for the week, its sixth consecutive one-week advance, bolstered by the prospects for tax reform. Recent reports have highlighted massive outflows from U.S. equity funds, but that headline tells only half the story. Actually, we’re experiencing a tale of two investment styles. For the year-to-date period ending September 30, actively managed funds have shed almost $150 billion in assets, whereas passive index mutual funds and exchange-traded funds have taken in more than $70 billion, according to Morningstar.

In overseas markets, Europe’s STOXX 600 Index fell 0.7% in dollar terms. In addition to some disappointing earnings releases, shares were once again saddled by Spanish stocks. Tensions between Spain and Catalonia deepened, as the central government took steps to impose direct rule on the country’s wealthy northeastern region after the Catalan president refused to renounce a secession bid.

Below the fold: Care for your data hard or soft?

Throughout much of the year, “soft” economic data (based on sentiment surveys) has remained relatively strong and in some cases accelerated. Meanwhile, “hard” data (measures of actual economic activity), in aggregate, has stayed relatively weaker. We saw another example of this divergence during the past week, as homebuilder confidence rebounded in October to a five-month high, according to the NAHB index. However, housing starts tumbled 4.7% in September and building permits fell both last month (-4.5%) and on a year-over-year (-4.3%) basis. Existing home sales did edge up 0.7% in September.

Meanwhile, the Conference Board’s index of leading economic indicators declined in September for the first time in 12 months, partly reflecting the impact of Hurricanes Harvey and Irma. Despite the dip, the trend in leading indicators remains consistent with continuing solid growth in the U.S. economy for the second half of the year.

On a positive note, after spiking last month in the wake of the hurricanes, first-time unemployment claims plunged by 22,000 to 222,000, their lowest total in 44 years. The less-volatile four-week average also declined, by 9,500, to 248,250.

The Back Page: China’s 19th Party Congress and its economic growth paradox

On October 18, China’s twice-a-decade National Party Congress commenced with another wide-ranging agenda presented by President Xi Jinping, his second since assuming power in 2013. In addition to broadly setting the Communist Party’s policy for the next five years, Xi set key objectives on foreign policy, technological innovation, and clean energy, while addressing steps to curb widespread financial risks across the economy.

Although Xi hailed this next phase as a “new era” of global leadership, his dilemma will be how to continue financing ambitious objectives in an economy that's arguably strained. Since the global financial crisis, the Party has backstopped GDP growth of around 7% even when investment or private-sector spending has languished. Achieving Xi’s new “socialist modernization” seems to require maintaining this robust pace. As a result, it’s no surprise that the Party Congress kicked off with the announcement that third-quarter GDP had clocked in at 6.8% year over year, precisely in line with expectations.

Over the past few years, leverage has increased across China’s household and corporate sectors. The country’s ratio of household debt to GDP just reached 45%. Furthermore, individuals are dialing up risk by shifting savings from a stretched housing sector to a plethora of poorly regulated wealth management products. Moreover, total debt (i.e., government and corporate) is expected to rise to three times the size of GDP by 2022. These longer-term risks, however, do not yet seem to seriously threaten China’s ability to prop up economic growth or move its five-year agenda forward.
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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