Fed preview: Take it easy…

Looking back at what has happened over the past four months you would have to say policymakers have done a great job at calming what at one point was a pretty febrile environment.

In August equities were selling off, the yield curve was inverted - historically a strong predictor of recession - and activity data was starting to soften. Since then we have had hints of a US-China trade deal, but we have also had three interest rate cuts from the Federal Reserve totalling 75 basis points. Equities are up more than 10% back to new all-time highs, the yield curve has re-steepened while a better balance to the macro data has provided greater optimism that a recession will be avoided.

Looking back at what has happened over the past four months you would have to say policymakers have done a great job

After the rate cuts in July, September and October, Federal Reserve officials have indicated a preference to pause. The minutes from the 30 October Fed meeting stated that “participants generally viewed the economic outlook as positive” and while there was a majority to cut interest rates at that meeting, “a couple” of members who voted for the 25bp cut thought it was a “close call” decision.

Individual Fed speakers have reinforced the message that there needs to be a “material” change in the economic outlook for them to implement further rate cuts. Friday’s remarkably strong jobs report confirms that this week’s decision will result in a “no change” outcome with the press conference emphasising the data dependency for future decision making.

We will also get an update of the Fed’s forecast versus those published in September and a new “dot plot” on predicted path of interest rates. In terms of their macro forecasts, we are only likely to see near-term revisions lower to the unemployment rate projection given the latest officials data.

They will also have to lower their 2019 forecast for the Fed funds rate given they didn’t predict their own October rate cut in September. Currently, they are suggesting the next move is a rate hike in 2021 and we suspect this will remain the case.

Like the market, we continue to see the risks skewed towards more rate cuts before an eventual hike. While Friday’s jobs numbers were fantastic other data suggest that the US economy is slowing. Capital expenditure has contracted in both 2Q and 3Q19 with the durable goods report hinting at a likely third consecutive fall in 4Q19.

The latest ISM business surveys softened again while the external environment remains weak with German industrial numbers and Asian trade data reinforcing this message. Given this situation, we suggest that renewed slowing in job creation is the most likely path ahead through 1H20.

Trade tensions also remain a key issue. It may well have been that optimism after President Trump announced a phase 1 deal with China concerning agriculture products gave a lift to sentiment and activity. However, the fact we are now two months on and there has been no signed deal underline the message that trade remains a very challenging area.

President Trump has suggested he is prepared to wait until after next year’s election to conclude a deal while White House economic advisor Larry Kudlow stated that “if the agreement isn’t complete, our current law will restore tariffs”, implying that another wave of 15% tariffs on $156 billion of consumer goods from China could go ahead as scheduled on 15 December. It is possible that this gets delayed, but the uncertainty that this all generates leaves us to conclude that trade will remain a major headwind for growth in 2020 by disrupting supply chains, hurting profitability and damaging sentiment.