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The US Federal Reserve – Fearing their Own Shadow
4th February 2019
Gary Dugan
By Falco Group
Investment Committee
  • Fed in a constant state of fear of sending the markets into a tail spin dragging down the economy
  • Risk markets rally in hope that Fed will not have the stomach to tighten policy
  • We fear heightened volatility as the Fed and other central banks withdraw QE stimulus
  • Brexit drama looks likely to drag on beyond the initial deadline
  • Potentially some of the worst Brexit outcomes have fallen
  • Sterling marking time after recovery and stabilization

The angst in the Federal Reserve is almost palatable. Every time there is strong US economic data the Federal Reserve intimates that they are going to stick to their plans of increasing interest rates and reversing quantitative easing. However, as soon as the market fears the Fed will really carry out their plans, the financial markets sell-off. And, as soon as the markets sell-off the Fed gets worried and seemingly backtracks on its plans. The financial markets rally, and the economy re-accelerates. What a game, what a mess.

For choice, it seems risk assets may rally further although the equity market’s modest rally post the announcement from the Fed suggests that investors are somewhat fearful of chasing the rally. The fact that gold has maintained its strength above $1300 shows that the flip-flopping of Fed policy only further undermines the concept of fiat money.

In dealing with the hurricane that struck global markets a decade ago, the US Federal Reserve had to deploy many unconventional tools such as underwriting of mortgage-backed securities, interest rate forward guidance and in particular a massive expansion of its balance sheet to drive down long-term interest rates. At its peak, the US Federal Reserve balance stood at $4.5 trillion as against $1 trillion pre-crisis. Historians will debate the impact of these initiatives for years to come.

Quantitative easing whereby central bank balance sheet expansion added to bank free reserves and expanded the economy’s monetary base is giving way to the opposite with some unforeseen damaging effects on money and asset markets. The task in particular for the Federal Reserve to smoothly roll back quantitative easing is key to the performance of financial markets in 2019. Chairman Powell and the FOMC are grappling with trying to slow a robust US domestic economy with tighter monetary policy but against a backdrop of a slowing global economy and skittish financial markets.

The scale of turnaround from quantitative easing to modest quantitative tightening is quite staggering. Citi analysts calculate that central banks who bought assets at a peak annualised rate of over $2.5 trillion a decade ago were passive net sellers of over $0.5 trillion over the last year - led by the Fed as they stopped re-investing the proceeds of maturing bonds back into the bond markets.

The slow bond selling has led to tightening liquidity in money markets resulting in erratic overnight interest rates with a knock-on impact on other markets such as the repo market in a range of securities. Markets are ultimately about expectations and nowhere more so than with the path of credit growth into the future. Earlier, the Fed leadership, in preparing for the end to super-easy monetary policy had signalled that the reduction would happen at a set pace with the calibration in speed and intensity of tighter policy driven by raising interest rates. That mantra was repeated as recently as last December and was shared as a broad consensus by other tightening central banks.

In a surprise move, the Fed decided last Wednesday to throw the previous policy overboard suggesting there is no automatic pilot on balance sheet shrinkage and hinting that the slow reduction might be halted if conditions warranted it. Admirable though that might be as an indication of policy flexibility, it adds even higher risk to how the market might interpret the Fed’s intentions at a time when less is desirable. The impact we feel will be felt in the long end of the Treasury bond market and the US dollar where the ‘policy risk’ premium will be higher. Not a catastrophe certainly but surely a test that central banks should have seen coming when considering that quantitative tightening must bring with it some old-fashioned pain, just like any other ‘ordinary’ tightening cycle. Ironically the Fed shifted its policy stance in a week when the ISM survey of manufacturing sector confidence came in well ahead of expectations at a level which is consistent with a 4% rate of GDP growth. Also, employment growth was strong both in the jobs report and the ADP private employment survey.

Equity markets responded positively to the Fed’s backtracking with the S&P500 up 1.6% on the week. Equity markets will take heart from the Fed’s reluctance to push too hard on tightening too quickly. However, remember that this is also a Federal Reserve that has seemingly changed its minds many times over the course of just the last few months.

Another round of Brexit drama passed with possibly the extreme outcome of a no deal slightly reduced and hopes raised that some compromise can be found with the EU. Sterling slide but maintained a level above $1.30 and it remains above the levels of deepest despair in early January. The likely pushing out of a final final date for Brexit only adds to the sense that there is still time to take positions for an eventual outcome.

One aspect of the Brexit saga is seen in the endless stream of jargon and acronyms that have flowed from the prolonged negotiations; this week’s offering is a ‘joint interpretative instrument’ Don’t even ask; if curious enough please Google it and its use when the EU hit a roadblock in ratification of its free trade agreement with Canada. Suffice to say, it concerns the effort of squaring the circle of the Irish backstop in a legal form.

One further element of the Brexit drama is the repeated attempts to see some set of events as a crucial turning point in the process. Last weeks’ happenings in the British Parliament may well prove to be so. We still feel that on balance a deal will eventually be agreed to allow for an orderly Brexit although the confidence intervals around that call ebb back and forth. We think the significance of the votes in the Commons was to help reduce the prospect of ‘No-Deal’ while potentially at the same time shrinking the risk of ‘No-Brexit’. There will be another meaningful vote on any deal agreed in Europe; Tories can finally unite behind a strategy even if temporarily and there is a clutch of 20-30 Labour MPs who are prepared to back the government.

The sound of the UK government shifting on the extension to the Article 50 deadline beyond March 29 is fairly deafening at this point. The EU will almost certainly accede to the request, perhaps with a delay as far out as the year-end if the issue of the UK participating in the European Parliamentary elections can be circumnavigated. That significantly reduces both the prospect of the ‘No-Deal’ even if it involves even more debates and votes in Parliament. There will be another meaningful vote but this time the government will look to be a lot surer of victory and if necessary, have some tacit backing from the Labour party leader Jeremy Corbyn.

The real flex here is again time. There is a minimal prospect of an amended version of the Withdrawal Agreement or complementing treaty, however modest, being signed off by the EU by Mrs May’s suggested date of February 13th. We could very quickly arrive at sign-off by the other EU27 leaders at the next formal Council Meeting on March 21, just days before the currently assumed Brexit Day. Indeed, it is proving politically nerve-wracking and dramatic. However, the bigger story here was seen in part with Nissan’s announcement to cancel a proposed increase in its UK production lines as well as City institutions decisions on moving part of their balance sheets outside of the UK. Brexit is beginning to have some real-life consequences in 2019. That, in turn, will shape the debate driving toward domestic UK agreement. For the moment sterling is likely to mark time, as it discounts, even more, jaw-jaw in Europe and London. Early success will come as a surprise, but the more significant risk now is that underlying weakness invites comment and potentially a halt to the tightening cycle from the Monetary Policy Committee. This is a series that is proving to be one very big box set.