Global Daily – Market volatility unlikely to derail the Fed

by: Bill Diviney , Arjen van Dijkhuizen

Fed View: Futures markets likely too aggressive in pricing out rate hikes – Recent market volatility has led to reduced market expectations for Fed rate hikes. At their peak in mid-May, futures were pricing a further 53bp in tightening – just over two full further rate hikes – by the end of 2018. This has since declined to just 40bp, with a particularly sharp fall following the Italian political turmoil of the past week. The Fed is indeed mindful of external developments, and there is a precedent for the FOMC to hold off from rate hikes in periods of heightened uncertainty and market volatility (think of China in 2015, and Brexit in 2016). While we think the risks in Italy remain significant (see here), and emerging market volatility is a concern for some countries (see here), we believe the Fed is more likely this time to look through the current phase of volatility and to proceed with gradual rate hikes, for two main reasons.

First, the domestic risks facing the US economy are arguably tilted to the upside. A significant amount of fiscal stimulus is coming on stream when the economy is by many measures close to full capacity, and growing at an above-potential pace. While the risk of an escalating trade war remains real, tariffs (or the threat thereof) have so far had a bigger impact on input pricing than on business confidence. Second, comments from Fed Chair Powell earlier in May suggest he is less minded to link emerging market volatility with the actions of the Fed, and that markets ‘should not be surprised by our actions if the economy evolves in line with expectations’. We view this as a strong signal that there would be a high bar for the Fed to pause on the back of external developments alone – provided of course that there is no contagion to the US economy (our base case).

While many FOMC members are closely watching the flattening yield curve, and a continued decline in 10y yields could yet stay the hand of more dovish members, our base case remains that the Fed will hike by 25bp at each press conference meeting until June 2019, taking the upper bound of the fed funds rate to 3.00%. (Bill Diviney)

Asian Trade: China solid, bellwethers slowing – China’s official manufacturing PMI for May came in stronger than expected today, at an eight month high of 51.9 (April: 51.4). This suggests momentum in the Chinese economy remains strong, despite drags from ongoing targeted tightening policies and rising external risks. Against this backdrop, developments on the foreign trade front have been better than expected so far this year, despite rising trade and investment tensions with the US. For instance, the consensus expectation (including ours) was for a material slowdown of China’s import value growth in 2018 (after a stellar 2017), but this has yet to happen. Looking through Lunar New Year (LNY) distortions, import and export growth have held up well in January-April 2018. Although in February – when China Inc. was closed for one/two weeks due to LNY festivities – imports from (for instance) Germany and the EU dropped sharply, we have seen a sharp rebound in subsequent months. Notwithstanding China’s trade resilience, global PMI export subindices have come down in recent months, particularly for emerging markets (note that China’s official export subindex fell back below 50 again in May). That is an early indication of risks to the global trade (and growth) outlook. In fact, export growth of the Asian bellweathers (South Korea, Singapore, Taiwan) is on a downward trajectory, suggesting that the peak in world trade growth is already behind us. The slowdown of these countries’ electronic exports suggest that the global tech cycle is cooling. For more background, see our Short Insight – Asian trade: China solid, bellweathers slowing published today. (Arjen van Dijkhuizen)