Investors looking to predict the Fed’s future monetary policy should focus on financial conditions indicators, according to both BlackRock and Capital Economics.
US interest rate changes move global stock valuations. Last year, the threat of a rate hike caused volatility in equity markets from Australia to Canada, so it pays to keep an eye on the Federal Reserve.
Over the past two meetings of the Federal Open Market Committee, which sets interest rates across the pond, it has pivoted from hawkish to dovish to extremely dovish. After four rate hikes in 2018, futures markets are currently pricing in zero for 2019.
This has allowed both equity and bond markets – emerging indices in particular – a January bounce from their poor performance in the final three months of last year.
The Fed’s change in language – from “further gradual increases” in rates to “future adjustments” – has set debate raging.
Some economists believe that means we could see cuts coming; others think the central bank will simply pause before looking to resume its hiking programme later; the third faction believe we’ve now reached peak rates and they’ll stay at this level for a good.
Fed chair Jerome Powell outlined a number of risks as reasons for his new dovish tone, including slowing global growth, geopolitical events like Brexit and ongoing trade uncertainties between the US and China.
But another metric that concerns Powell is the tighter financial conditions seen since the fourth quarter of 2018. And commentators at both asset manager BlackRock and research house Capital Economics believe this measure is key to determining the Fed’s course going forward; albeit they disagree with how things play out in the next 12 months or so.
Numerous industry experts produce indices of financial conditions around the world. These indices attempt to describe how the prices of financial assets and the real economy interact with each other. The more financial conditions tighten, the more they drag on growth; the more they ease, the more they support growth.
Crucially, notes Neil Shearing, group chief economist at Capital Economics, financial conditions have tightened in the run up to most downturns in G7 economies.
What we saw in the final three months of 2018 was exactly that – BlackRock’s bespoke financial conditions index saw a big drop, of 40 basis points, from October through December. “That is a very bad signal for where the economy is going,” says Isabelle Mateos y Lago, chief multi-asset strategist at BlackRock.
Why the Fed Changed Tack
Speaking at an investment summit for clients of Nedgroup Investments at the London Stock Exchange on Monday, Mateos y Lago said this tightening of financial conditions was the key reason for the Fed’s change of tack. “They realised that the market had delivered far more tightening than they intended to do with, say, an extra rate hike,” she adds.
As a result, the Fed felt comfortable they could take a pause on their hiking programme in the hope they can help to undo the tightening. That has played out to some extent, with equity markets rallying and credit spreads narrowing in the year-to-date.
Mateos y Lago notes, though, that markets have only retraced around a third of the fourth quarter’s tightening; Shearing says conditions have only stabilised, rather than eased. Good news, but nothing to get carried away with just yet.
Shearing says a chart of financial conditions is the one chart worth watching through the course of the year. His sense is that financial conditions will start to tighten once again, which would mean we’re likely to feel the consequences through a further slowdown in growth over the coming quarters.
This plays to colleague John Higgins’ view that the role of quantitative easing in driving risk assets, particularly the S&P 500, has been “frequently exaggerated” and, therefore, any scaling back of quantitative tightening “won’t save the US stock market”.
Capital Economics thinks the global economy will continue to weaken, leading the S&P 500 to end 2019 at 2,300 – 15% below today’s level.
While, Michael Pearce, senior US economist at Capital Economics, believes the slight easing of financial conditions seen in recent weeks will prompt the Fed to raise rates once this year – in either April, May or June – it will cut rates by 75 basis points through 2020.
Chances for Growth
Mateos y Lago sets out a more hawkish way forward. “If markets continue to behave in a very happy way like they’ve done in the first quarter, financial conditions are going to pick up and the economy is going to start re-accelerating,” she says.
This will likely see the Fed look at the US’s very tight labour market and inflationary pressures that are in line with their target and re-evaluate its stance. “In reality we may be one or two quarters away from the Fed feeling that it needs to move again.”
Another with a constructive view on the US economy is Mark Dowding, co-head of developed markets at BlueBay Asset Management. The easing in financial conditions may stimulate activity further, with two hikes expected in 2019.
“Consumer disposable income is growing thanks to employment gains, higher wages and lower taxes,” he says. “Although consumer sentiment dipped last month, it could rebound swiftly.”
