A dove with claws

Published at 17:01 14 Dec 2018 by

Please note that this is the final Macro Digest of 2018. Normal service will resume on 11 January. We wish our readers a prosperous 2019!

Two of our three ‘great expectations’ events, which we wrote about two weeks ago (see Macro Digest: Great expectations, 30 November 2018), have resulted in outcomes that the market was hoping for: OPEC agreed to cut production by 1.2 mb/d and a dinner at the G20 delivered a pause in the trade war escalating between the US and China. But in both cases, initial price jumps in oil and equities triggered by the headlines evaporated quickly as doubts over the commitments permeated. In short, while the outcomes were what markets wanted, the follow through and conviction was lacking.

For the oil market, OPEC’s six-month cuts will help to avert a catastrophic rise in liquids inventories in H1 19 and our balances now even show a small draw of 0.15 mb/d, especially once the mandated Canadian cuts are taken into account. But given the heavy refinery maintenance schedule, crude stocks are unlikely to draw materially, which will not help turn sentiment around. H2 19 balances look more constructive even if the deal is not extended—so long as OPEC+ does not raise production to the extreme levels seen in November this year—although given the market fears an imminent demand slowdown, it would want to see an extension of the agreement to be sure that stocks do not rise. Most importantly, however, the market did not see the fire in Khalid al-Falih’s eyes that was there in May 2017 when he spoke of cutting exports to the USGC. This time around, clear signposts were lacking.

As for the G20, the reality is that the US and China have merely carved out a 90-day grace period, or a stay of execution if you prefer, which the market does not think is that long and will also be eaten into by the Christmas and then Chinese Lunar New Year (in Q1 19) holidays.

The equity market rallied on news of the 'breakthrough' at the G20 meeting on 2 December, only to give back the gains in the days afterwards, while oil prices popped on the Thursday morning of the OPEC meeting (6 December) as news of an agreement to cut oil production began to percolate, only to retrace much of the move in the afternoon. Both were classic buy-the-rumour, sell-the-news moves.

Part of the reason that the equity market was unable to sustain a rally after the G20 is because the US-China trade war has exacerbated the current slowdown in the global economy but is not the cause. The global economy has been slowing because of tightening dollar liquidity, which is wholly a function of the US Federal Reserve’s tightening cycle. Next week, the third of our ‘great expectations’ is likely to be also realised as the Fed meets and will probably hike interest rates again. The only question for the market now is whether the Fed will affirm four more rates hikes in 2019, or if Jerome Powell has turned dovish. The market’s perception, regardless of the reality, will be meaningful for near-term markets.

A hawk in dove’s clothing
The market is now obsessing over pinpoint estimates of exactly when the Fed stops hiking rates and when the recession begins. Comments from the Fed Chair in October and again in recent weeks have been widely—maybe even wildly—interpreted to suggest that the Fed is going to slow the pace of rate hikes dramatically in 2019. Then, in late November, Powell’s comments in a speech at the Economic Club of New York were taken as confirmation at what was hinted the previous month—expectations for a Fed ‘dovish pivot’.

Many banks have scaled back their forecasts for rate hikes in 2019, most notably Goldman Sachs paring its expectations for four hikes in 2019 to three earlier this week, along with many others. But there is also an ever-growing chorus of analysts who believe that next week’s rate hike will be the last of the current Fed tightening cycle.

The timing of the Powell speech in October intersected with a market that was extremely long the dollar, just as the consensus was turning bearish on the broader economy because the US-China trade war was beginning to bite. The markets were already on high alert for any hint of dovish signals from the Fed chair, given positioning in both the dollar and in equities. The market heard what it wanted to hear.

We disagree with the assessment and believe that the Fed chair was merely stating facts rather than signalling intent. So the market could be setting itself up for disappointment once again. The Fed’s attitude towards rate hikes has not changed, just how it talks about them publicly has changed. We do not believe the Fed has altered its interest rate path. But there will be a lot of room for miscommunication again next week. Powell, for example, could affirm the hike and the positive model outlook, but he could also note that risks have grown more symmetrical and that a pause in hikes was discussed at the meeting. This of course would be straight out of the European Central Bank playbook. We believe the market truly wants to hear that the cycle is done, but in reality, it is unlikely to get that much explicit dovishness. If the meeting next week releases a dove, it will be a dove with claws.

Two-speed economy
In part, our belief is driven by the fact that from a growth perspective, it is not clear that the US data has unambigiously softened. Inflation is not showing signs of slowing sharply despite some of the optics around commodities and other goods. As a case in point, we just got the second-highest core CPI reading of the year and all the anecdotal evidence is that wage pressures and non-tradable (service) prices continue to move incrementally higher. This is not to say that there are no headwinds. Auto sales have slowed and the housing market is contributing to a wider slowdown in growth in the US economy. But we merely want to point out that the data is inconclusive, and parts of the economy could continue to indicate acceleration. Given its dual mandate, the Fed cannot ignore that.

Certainly, US economic growth is slowing. But the fact is that growth should be slowing, and this was the Fed’s goal—to cool the economy by slowing down aggregate demand in order to reach a more sustainable growth level. This should not surprise anyone. If anything, Fed officials remain impressed by the fact that the US economy continues to run well above potential even in the latter innings of the second-longest expansion on record, after eight rate hikes and despite a weakening global backdrop and the strength of the dollar.

Fig 1: 5-yr UST yield vs S&P % change y/y Fig 2: US exports, % change y/y
Source: Bloomberg, Energy Aspects Source: US Census Bureau, Energy Aspects

Reaction function junction
For us, two things suggest the Fed is going to be far more reactive than perhaps the market understands. Again, it would be wholly out of character for the Fed to proactively pause rate hikes before their effects are clear. Powell caveated his comments both in October and November greatly, but the market chose to interpret selectively. We thought that his comments that the economic effects of the Fed’s gradual rate increases may take a year or more to be fully realised were important. For us, the choice to emphasise the long lag between monetary tightening and its impact on the economy confirms that the Fed will depend as much on data as ever, and thus will be reactive rather than proactive. Vice Chairman Richard Clarida’s comments last week echoed Powell’s by noting that neutral rate estimates are highly uncertain and, as such, participants will be revising their estimates based on incoming data at each Federal Open Market Committee (FOMC) meeting. In reality, the Fed is still saying exactly what it has been saying for several quarters, just with a different accent. The Fed is going to get to the same level of interest rates that it intended at the start of 2018 but is doing so with a more dovish tone.

Markets do not really care about current fundamentals but rather expectations of future fundamentals combined with a large and difficult-to-quantify downside risk from trade and the broader global environment. We would argue that there is plenty of evidence out there that the Fed has not (yet) overtightened, even if we can all endlessly debate about where neutral actually is. Moreover, while backward-looking, the strength of the labour market in the US and the ongoing momentum in wage growth puts a solid floor under growth in 2019 in our view, even if acceleration will be difficult. And there are still plenty of reasons to think that the anticipated and much-feared deceleration may not happen, at least in 2019, or may occur much more slowly than people expect.

And so, what are potential sources for optimism in 2019?
There are more reasons to be optimistic than the market may realise. The market thinks the impact of tax cuts is clearly exhausted, but that may not be completely true and there is still a debate as to whether the benefits have completely run their course. US defence spending is surging again. In the meantime, in Europe, we expect France to do an about-face and enact major stimulus, which may in turn open the way for Italy to do the same. The risks around trade conflict between the US and China are massive, and there will surely be brinksmanship at the 90-day deadline. But in the short-term, there has been an easing in tension and both sides have incentives to find a solution. There are upside and downside risks in 2019 for US-China trade, but we feel the focus is slightly tilted towards the downside. If the trade risks have bottomed, the sell-off in oil prices may end up as a goldilocks treatment for the US, enough to give a boost to consumer spending but not enough to cause investment to crater like in 2016. But for big oil importers (Turkey and India among others), the fall in oil prices is an unambiguous positive.

We are not saying that all these things are definitely going to happen in 2019, but the market is ignoring them as potential positive catalysts. Much like early in 2018 when the market was overly optimistic on the expectations for growth this year (see E-mail alert: The reintroduction of two way risk, 5 February 2018 and E-mail alert: Dollar liquidity and the risks to risk, 21 March 2018), we feel that it has become overly pessimistic on the prospects for growth in 2019. Thus, the only thing that could actually lead to a decisive pause from the Fed in hiking rates is an abrupt economic downturn appearing unequivocally in the data. While we do expect the economy to slow, that still seems some way off. As such, we could still see two to three more rate hikes in 2019 after a December hike, even if there remains a perception of a dovish pivot from the Fed next week.

Yasser Elguindi, Energy Market Strategist
+1 646 760 8100 (direct)

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