Better late than never

Published at 16:30 21 Jun 2019 by . Last edited 17:33 21 Jun 2019.

The Macro-Digest will take a two-week break, due to holiday and travel schedules, returning on 12 July. In the interim, we will keep you updated on developing stories via E-mail alerts. 

Last week we highlighted three key events that would go a long way towards setting macro risk appetite for H2 19: the Fed, OPEC and the G20 meetings (see Macro-digest: Crossroads, 14 June 2019). After what feels like an age, OPEC has finally confirmed that its next meeting will be held on 1 July and the OPEC+ meeting will follow the next day. Our expectation remains that the most likely outcome is a rollover of the current 1.2 mb/d cut, but we will write more on this next week as the date of the meeting draws near. But oil prices surged this week as tensions between the US and Iran spiked when Iran downed a US drone. While the US has thus far showed restraint, US Centcom is currently coming up with retaliatory options to deter further Iranian aggression. These tensions are unlikely to subside anytime soon (see E-mail alert: US-Iran: Redefining red lines, 21 June 2019)

The divergence between the bond market and the equity market continues to grow and represents a potential pitfall for policy. But with inflation expectations so low, the Fed can continue to focus on extraordinary measures as macro weakens. Even so deep in the business cycle, it appears that market dependency trumps data dependency for the Fed. This is the world we live in—where bad news is good news as easy money drives risk assets higher. Clearly right now, with the surprise dovish stance from the ECB and a clear easing bias from the Fed, risk assets have been boosted on hope for additional rate cuts, as well as a positive outcome at the G20 meeting on US-China trade talks.

Fig 1: Equities vs Treasuries Fig 2: Crude oil price, % change
Source: Bloomberg, Energy Aspects Source: Bloomberg, Energy Aspects

Finger on the trigger
Meanwhile, this week the Fed delivered the security blanket that the markets had been hoping for when it clearly signalled an easing bias by highlighting that it is monitoring downside risks to the economic outlook. Powell effectively communicated that the Fed hears the alarm bells and thus has one finger on the trigger and won’t hesitate to pull it.

Any lingering doubts were cleared up in his press conference. Digging into some of the more nuanced messaging, the fact that there are so many members now expecting cuts as reflected in the dot plot (seven dots calling for two cuts and staying there for at least two years) even as inflation is not expected to get back to 2% until much later suggests that the bar to a deeper cutting cycle is extremely low.

In short, Powell is effectively pre-announcing a cut in July, with market pricing currently at 30 bps. Right now, the market is wondering what the hurdle is to the Fed doing a 50 bps cut, given that a 25 bps cut seems to be as good as done. But more importantly, with the market pricing three or four more cuts over the next 18 months, arguing whether or not the Fed cuts 25 or 50 bps in July is missing the forest for the trees. It would perhaps be wiser to be asking: now that the Fed’s reaction function has shifted, what is the terminal rate?

Between the Fed and the surprise dovish pivot from Mario Draghi earlier in the week, the market now believes that central banks are in easing mode and all that means for risk assets. The set up will be incredibly strong, should Trump be able to deliver some positives out of the meeting with Xi at the G20. Of course, we do not expect any sort of grand bargain with China, and the best outcome at this stage would be yet another ‘ceasefire’ that allows for real negotiations to continue. The really interesting development and consideration is that in the event that somehow Trump and Xi pull a rabbit out of the hat, and do manage to announce a meaningful trade deal in Osaka, would the Fed still cut rates in July? Our view is that if there was a real deliverable deal on the table, then it would more than likely forestall further Fed cuts. However, what happens if they only deliver a ceasefire as we expect? We think this is now market consensus, so it would very likely take really strong data (and in particular payrolls, the May PCE and the June CPI) to get the Fed back on hold.

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

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