Quarterly Outlook
Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges
Althea Spinozzi
Head of Fixed Income Strategy
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As BASF sounds the alarm on global demand, the Fed can still cut despite strong jobs
Summary: Monthly update covering the US/China trade dispute, the US job report and the FED.
Bullet summary:
- Trade disputes delayed not resolved
- Strong jobs nullify 50BP rate cut
- A 25BP cut can still come on the basis of:
- low inflation,
- drag on US growth from global forces,
- trade uncertainties hit manufacturing – slowdown risks permeating the service sector and consumption,
- inverted yield curve, and NY Fed recession probability rising
- drive a weaker dollar
- Powell testifies to congress on a tightrope of market expectations
Main Text:
The week has kickstarted with a risk-off tone after Non-farm payroll numbers on Friday set off renewed caution amidst repricing of an aggressive 50BP June rate cut.
The hype of the US/China resuming talks has faded quickly as market participants remain cognisant that the Trump/Xi meeting in Osaka and agreement to continue talks represents ongoing trade disputes that are delayed not resolved, providing merely a short-term sentiment boost. Uncertainty still reigns large as there is nothing predictable about the current US administration and trade deal with China, or not, trade and protectionism will be a persistent theme. Trump's recent attack on Vietnam, a supposed trade war winner, whom he dubbed “almost the single worst abuser” of trade is proof enough of this.
And just this morning newswires confirmed the US plan to impose duties on structural steel from China and Mexico, confirmation of omnipresent trade tensions. The US Trade Policy Uncertainty Index is surging.
On the possibility of an eventual deal with China, our thoughts have not changed. It is our thinking that the prospect of a trade deal depends largely on Trump’s calculation of how it would benefit his re-election. Trump appears to be guided by his calculation of whether a deal would score points with voters, which could shift in either direction at any moment. Right now – why back down? Polling isn’t suffering, equity markets are hovering around all-time highs and the Fed have been bullied into a corner ready to buy markets. A bad deal would likely be worse than no deal at this stage.
On the prospect of central bank stimulus, bad news is good news. The worse the outlook for the economy the more likely central banks will step in with aggressive easing measures. So, the bounce back US non-farm payrolls report has thrown a spanner in the works. The NFP headline jobs number increased 224,000 in June, beating expectations (160,000). Unemployment crept up to 3.7%, but this was driven by increased participation, and is still hovering around 50-year lows. But despite the robust headline number, wage growth was just 3.1% YoY, below market expectations.
The sharp rebound in job creation from just 72,000 (revised down from 75,000) in May means a 50BP cut is off the table, especially considering that according to the dot plot at the June FOMC meeting 9/17 members didn’t forecast even 1 rate cut this year. Even Perma-Dove Bullard, President of the St. Louis Fed, prior to the NFP didn’t sound ready to cut 50BP. However, a 25BP cut is still in play the market remains 100% priced for a cut at the July 31st FOMC meeting. At this stage, if the Fed decided not to move, the reaction in equity markets and cost of not delivering would be violent. The Fed is trapped as equity markets have been propelled to fresh all-time highs off the promise of stimulus rather than healthy corporate earnings. Fed members have dictated their end goal is to “sustain the expansion,” this means a financial market meltdown must be avoided and is one reason why a July rate cut is incoming.
On the prospect of central bank stimulus, bad news is good news. The worse the outlook for the economy the more likely central banks will step in with aggressive easing measures. So, the bounce back US non-farm payrolls report has thrown a spanner in the works. The NFP headline jobs number increased 224,000 in June, beating expectations (160,000). Unemployment crept up to 3.7%, but this was driven by increased participation, and is still hovering around 50-year lows. But despite the robust headline number, wage growth was just 3.1% YoY, below market expectations.
The sharp rebound in job creation from just 72,000 (revised down from 75,000) in May means a 50BP cut is off the table, especially considering that according to the dot plot at the June FOMC meeting 9/17 members didn’t forecast even 1 rate cut this year. Even Perma-Dove Bullard, President of the St. Louis Fed, prior to the NFP didn’t sound ready to cut 50BP. However, a 25BP cut is still in play the market remains 100% priced for a cut at the July 31st FOMC meeting. At this stage, if the Fed decided not to move, the reaction in equity markets and cost of not delivering would be violent. The Fed is trapped as equity markets have been propelled to fresh all-time highs off the promise of stimulus rather than healthy corporate earnings. Fed members have dictated their end goal is to “sustain the expansion,” this means a financial market meltdown must be avoided and is one reason why a July rate cut is incoming.
Aside from the market reaction, a valid argument for a 25BP cut remains. The Fed has signaled they have no appetite for a persistent disinflationary environment and that will be inducing them to ease policy sooner rather than later. The Feds reaction function has shifted, officials are increasingly worried about sustained low inflation. The Fed strives to achieve an inflation target of 2% annually, and recent readings have fallen consistently short of this. This is not a new phenomenon, nor one unique to the US but the Fed have become progressively concerned about what persistent low inflation means for their own credibility and inflation expectations. Testifying before Congress earlier this year, Powell singled out inflation expectations as “the most important driver of actual inflation”, hence the concern that the low inflation reality risks de-anchoring inflation expectations and thus becomes a self-perpetuating problem.
There is also the issue of trade uncertainty, the implications for manufacturing have already shown themselves. Already damage has been done to the global economy and a resumption in US/China trade negotiations won’t change that. The manufacturing bite is prevalent particularly in Asia and Europe which will create a drag on US growth.
There is also the issue of trade uncertainty, the implications for manufacturing have already shown themselves. Already damage has been done to the global economy and a resumption in US/China trade negotiations won’t change that. The manufacturing bite is prevalent particularly in Asia and Europe which will create a drag on US growth.
Incoming data continue to deteriorate, there were 10 manufacturing PMIs released last Monday, and all declined, with most of Asia in contractionary territory.
World trade volumes are declining as exports are falling, industrial production is falling, and manufacturing is decelerating, and the problem is not just trade wars, it is weaker global demand driving that story too.
Services and consumption are propping up the expansion so far. The fear is, this permeates through to the services sector and the consumer and you can already see signs of that infiltration in trade-sensitive areas like freight and shipping, which are signaling that world trade volumes are set to decline further. This is one reason why central banks around the world are being spurred into action and will move. To try and prevent a spillover from the contracting manufacturing sector through to services that then seeps into the labour market and consumption.
At the micro-level trade uncertainty and weaker global demand is visible in a multitude of industries and companies. Chemical maker BASF, the world’s largest chemicals company by sales, overnight cut their 2019 forecasts citing a weaker auto market and the ongoing trade spat. Earnings before interest, taxes and special items will be as much as 30% lower this year than in 2018. Chemical makers are positively correlated to global economic activity and global demand, chemicals are used in a wide variety of industries and applications so encompass a variety of end markets.
Despite all the dovish cooing to date, the dollar has failed to weaken. Dollar strength has been a significant hinderance to reflation, and it will be difficult to achieve a sustainable reflation without a weaker dollar so another reason why the Fed will cut, is to drive a weaker dollar. Comments from Trump indicate he and his administration will pursue a lower-dollar policy, either directly through verbal intervention or by forcing the Fed to cut deeper.
Another reason the Fed will move to cut rates stems from the yield curve inversion which historically signals that the risk of a recession is increasing, an indicator which the Fed should heed. The yield curve is the best forecasting tool for recessions, having inverted before each of the last seven recessions according to the National Bureau of Economic Research.
At the micro-level trade uncertainty and weaker global demand is visible in a multitude of industries and companies. Chemical maker BASF, the world’s largest chemicals company by sales, overnight cut their 2019 forecasts citing a weaker auto market and the ongoing trade spat. Earnings before interest, taxes and special items will be as much as 30% lower this year than in 2018. Chemical makers are positively correlated to global economic activity and global demand, chemicals are used in a wide variety of industries and applications so encompass a variety of end markets.
Despite all the dovish cooing to date, the dollar has failed to weaken. Dollar strength has been a significant hinderance to reflation, and it will be difficult to achieve a sustainable reflation without a weaker dollar so another reason why the Fed will cut, is to drive a weaker dollar. Comments from Trump indicate he and his administration will pursue a lower-dollar policy, either directly through verbal intervention or by forcing the Fed to cut deeper.
Another reason the Fed will move to cut rates stems from the yield curve inversion which historically signals that the risk of a recession is increasing, an indicator which the Fed should heed. The yield curve is the best forecasting tool for recessions, having inverted before each of the last seven recessions according to the National Bureau of Economic Research.
This inversion means that the interest rate (or yield) on 3-month US Government treasury bills is higher than the interest rate on 10-year Government bonds. Signalling that investors believe current growth is stronger than future growth and interest rates will be lower in the future. Banks borrow short and lend long, thus when the yield curve is inverted the ability to lend profitability is less and hence incentive to lend can be reduced, expectations of slowing growth also cause businesses and investors to slow spending.
Based on the past 7 decades, the lag between the inversion of the yield curve and the start of the recession is on average 22 months. In terms of monetary policy, an inverted yield curve has deep implications as it led all the past 6 Fed easing cycles of the past 3 decades and is likely to lead this Fed easing cycle as well.
Finally, the New York Fed recession indicator, as measured by the 3m/10s spread is placing the odds of a recession within the next year at 33%.
Based on the past 7 decades, the lag between the inversion of the yield curve and the start of the recession is on average 22 months. In terms of monetary policy, an inverted yield curve has deep implications as it led all the past 6 Fed easing cycles of the past 3 decades and is likely to lead this Fed easing cycle as well.
Finally, the New York Fed recession indicator, as measured by the 3m/10s spread is placing the odds of a recession within the next year at 33%.
This means Powell has a tightrope to walk in terms of market expectations when he testifies to congress this week or else things could get ugly. To pacify the market Powell will have to signal that the immediate 25BP rate cut is incoming but try not to get the market overexcited about much more than that. There is little headroom for Powell to disappoint without a tantrum ensuing, given the fed funds futures remain 100% priced for a July rate cut. If Powell were to push back on the market pricing and adopt a more patient stance there would be some sizable moves across rates, equities, USD and gold in the near term!
However, taking a more long-term horizon, the Fed will be easing along with other central banks like the ECB and the RBA. This leaves space to remain long front-end rates and play 2/5 curve steepeners in the US. A further rally in bonds would be supported as the recalibration in growth expectations will continue, from a year ago when we were talking about a 10yr yield heading to 4% to a realisation that growth is decelerating rapidly and disinflationary forces loom large, with central bankers now ready to ease again.
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