Central banks took centre stage last week, with a trifecta of major central bank meetings. The clear theme was that most major banks are at least taking small steps toward monetary policy normalization. However, the central banks that are tightening may be caught by surprise if the trade situation worsens – which I believe is a strong possibility.
Federal Reserve indicates another 2018 rate increase
First came the U.S. Federal Reserve (the Fed), which took a slightly more hawkish tilt at its June meeting in several different ways. First of all, it changed the language in its statement describing current economic activity: it is now rising “at a solid rate” versus a “moderate” rate as described in the May meeting announcement, with the Fed now expecting gross domestic product (GDP) growth for 2018 to reach 2.8%. The Fed also removed its assessment that “market-based measures of inflation compensation remain low.” In fact, it raised its inflation forecast for 2018 from 1.9% to 2.1%.
But perhaps most important, the Fed removed this critical expectation from its statement: the “federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run.” The Fed also removed language indicating that it expected the economy to grow at a pace that warrants only “gradual” rate increases. This change in sentiment was illustrated in the Fed’s revised dot plot, which now indicates a median of four prescribed rate hikes in 2018 and an additional three in 2019.
Following are my key takeaways from the June meeting of the Fed’s monetary policy-making arm, the Federal Open Market Committee (FOMC):
- In his press conference, Fed Chair Jerome Powell described inflation data as “encouraging,” but added that he didn’t “want to declare victory.” However, with unemployment at such a low level and with a very strict immigration policy, I don’t see how wage growth could remain flat. In addition, given the potential for tariffs to increase, I expect greater inflation when it comes to input costs. In short, I expect inflation data to pick up from here; however, given the Fed’s stated tolerance for overshooting its inflation target, I don’t expect the Fed to get more hawkish at this juncture.
- The Fed is not worried about a trade war at this point. In his press conference, Powell said he’s heard concerns and issues anecdotally, but it’s not showing up in the data. I think the Fed may be caught off guard if the tariff situation gets worse and places downward pressure on the economy. A fourth rate hike this year would exacerbate such economic pressure, and so I think we could see the Fed walking back its most recent policy prescription from four hikes to three in 2018. (By the way, I think it’s even more likely that we see the Bank of Canada walk back its recent hawkish statement following its May 30 meeting, which suggested it might raise rates as early as its next meeting in July. The Bank of Canada seemed to ignore the threat of a tariff war, despite worrying about it in previous documents, but was reminded of it in subsequent weeks as tariff rhetoric heated up.)
- It’s worth noting that the Fed will begin doing press conferences after each FOMC meeting starting in 2019. (Currently, it holds press conferences after every other meeting.) I believe this will increase the FOMC’s flexibility in terms of when it can announce rate increases.
- My biggest takeaway is that the economy is moving closer to an inverted yield curve. As of June 14, the spread between the 2-year U.S. Treasury and the 10-year U.S. Treasury was just 35 basis points – the lowest level we have seen in years.1 This may force the Fed to begin tinkering with and accelerating balance sheet normalization given concerns about the inverted yield curve articulated in the May FOMC meeting minutes.
European Central Bank plans gradual end to quantitative easing
The European Central Bank (ECB) also met last week and also became slightly more hawkish despite a first-quarter economic slowdown and instability in Italy. The ECB announced its plans for monetary policy tightening for the next year: it will continue its asset purchases at a level of 30 billion euros until September, at which time it will decline to 15 billion euros – the level at which it will remain through December. The ECB announced it will then end quantitative easing (QE) at the end of 2018, although it will keep rates at current levels until at least next summer.
The problem is that, unlike with the U.S. economy, the eurozone economy doesn’t appear to have improved following the first-quarter slowdown. And then there’s the instability surrounding the new Italian government, which includes ongoing concerns that Italy may try to leave the European Union.
Adding to headwinds for the European Union is the precarious situation German Chancellor Angela Merkel regarding a domestic immigration policy dispute; the coalition government that took approximately six months to pull together is in danger of being toppled, which could end her leadership. I don’t believe that will actually happen, but this situation just underscores the fragility of some governments in the EU.
I had expected the ECB would release a plan for further tapering but that it would not give a definite end date – similar to what it did when it initially announced tapering. However, it seems that ECB President Mario Draghi may have had to give in to monetary policy hawks on the ECB Governing Council. Fortunately, he did preserve two small escape hatches: this plan is conditional on “incoming data confirming the Governing Council’s medium-term inflation outlook,” and the ECB could resume asset purchases in the future if necessary.
Following are my takeaways from the ECB meeting:
- Many view the ECB’s decision as tilting dovish given its assurance that it will not raise rates until at least the summer of 2019. However, I continue to believe that QE is the far more powerful monetary policy tool, so stating a finite end date for it is hawkish in my view, given current macro and geopolitical conditions. I do take comfort in the ECB’s reservation of the right to restart the program, although I assume that would take extraordinary circumstances to be invoked.
- On the positive side, Draghi did suggest balance sheet normalization won’t occur anytime soon, explaining that ECB assets would be reinvested “for an extended period and for as long as necessary.” I believe this will be important in helping to hold down longer-term rates and in helping to keep a lid on systemic stress, which could worsen if anti-Euro movements within the EU gain momentum.
- I am worried about the potential for monetary policy error, given that Draghi even admitted that there is an “undeniable increase in uncertainty.” I believe that error potential is still relatively low; but I do expect it to rise as we come closer to the end of Draghi’s term in October 2019.
Bank of Japan retains dovish stance
Finally, the Bank of Japan (BOJ) also met last week and – unlike the Fed or the ECB – tilted dovish, maintaining its current ultra-accommodative monetary policy while also downwardly revising its forecast for inflation. As with the U.S. and the eurozone, Japan experienced a first-quarter slowdown. While data indicates the U.S. is experiencing a substantial rebound in the second quarter, as I mentioned previously, that is not the case for Europe (the U.K. in particular is experiencing a very significant slowdown) and it is not the case for parts of Asia. I believe China is in the midst of a very modest slowdown, and that will have repercussions for other areas in Asia and emerging markets. Having said all that, I do believe the Japanese economy will show improvement in the second quarter following a very disappointing first quarter.
My key takeaway from the BOJ decision is that it will likely lag well behind both the Fed and the ECB in rolling back crisis-era monetary policy stimulus, even though the BOJ began its stimulus well before that of the ECB. And this should come as no surprise; I don’t believe the BOJ has much of an alternative to ultra-accommodative monetary policy given its debt is so great that it would have difficulty servicing it if borrowing costs rise.
Concerns emerge about potential impact of trade policy
And so the common theme we have seen in the past several weeks is that central banks in general are normalizing monetary policy. The U.S. is of course a first mover in this regard, having started normalizing in December 2015, and it took a significant step forward at the June meeting. The ECB is following suit by announcing the end of tapering, and the Bank of Canada also appears to be preparing for further tightening with the statement from its meeting several weeks ago.
The only central bank in recent weeks that has dug its heels in for continued ultra-accommodation is the Bank of Japan. This suggests that in the short term, the dollar may likely strengthen relative to emerging market currencies, continuing a trend we have seen for weeks. I also expect that, in the short term, the dollar may strengthen relative to the euro and, to a lesser extent, the yen. I expect the yen to have significant support because it remains the “safe haven” currency of choice for Asia in an environment in which trade concerns are rising.
More importantly, I’m concerned that the central banks that are tightening may be caught by surprise if the trade situation worsens – which I believe is a strong possibility. Just last week, an International Monetary Fund (IMF) report warned that current tariff threats “… are likely to move the globe further away from an open, fair and rules-based trade system, with adverse effects for both the U.S. economy and for trading partners.” Christine Lagarde, Managing Director of the IMF, explained further: “The clouds on the horizon … are getting darker by the day. The biggest and darkest cloud that we see is the deterioration in confidence that is prompted by (the) attempt to challenge the way in which trade has been conducted …” This was further supported by an assessment from Federal Reserve Bank of New York President William Dudley in his last day on the job, who articulated what many economists and strategists are worrying about: “I am a little concerned that trade policy could evolve in a way that leads to higher trade barriers, and immigration policy could evolve in a way that leads to much less immigration in the U.S. and therefore less productive capacity for the economy.”
Markets are already beginning to price in these tariffs, with commodity prices pushed lower. Similarly, we’ve seen a sell-off in many agricultural, industrial and materials stocks that would be hurt by the recent tariffs announced by the U.S. and China. In addition, U.S. small caps have outperformed this year2 – all signs that markets are taking heightened protectionism seriously.
And so, while I believe the global stock market continues to have an upward bias, and despite a second-quarter economic rebound in certain countries, I think that bias is diminishing. I believe investors should be prepared for more volatility and the greater likelihood of a stock market sell-off in the coming months. I believe investors should stay vigilant and stay diversified (and talk to their advisors about the potential diversification benefits of small caps and alternatives).