Fiscal easing without monetary offset?

Week ending Friday October 20th 2017

Fascinating tensions playing out in markets. Undoubtedly, the biggest driver of market movements was the progress towards a big tax cut in the US Senate with seemingly little offsetting spending cuts in prospect. Normally such a deficit-raising, unbalanced outcome would drive an offsetting tightening of monetary policy. This time the tax cut is being played out against a background of leadership change at the Fed that leaves the Fed response uncertain.

Does Trump understand monetary offset and is seeking to prevent it with one of his famous deals? Obviously not. Could it be an unintended consequence of his actions? Maybe.

Reading the markets

Equity markets are totally focused on the potential tax cuts, especially the corporate tax cuts. Bond markets are clearly concerned about the inflationary impact. The short end of the yield curve continues to drift up, jumping several basis points on the Senate vote. The long end of the curve is also shifting up, implying that the short end rate rise will stick. If Fed rate rises were not likely to prove sticky, then long end yields would rise less than the short end – and the yield curve flatten or, in worst-case scenarios, invert.

The USD is continuing its slow recovery from the post-Trump slump. The upward move may indicate that markets believe that the Fed will act to offset, continuing with the tightening already in train. Fed leadership change could be crucial.

But what are the Fed leadership changes going to be?

Of course, the Chair is just one vote on the FOMC, but is also leader of the Fed Board of Governors. This Board tends to vote as a bloc, giving it an automatic majority on the FOMC – it is where the influence of the Chair is most obvious – also helping cement that power is the constant rotation of regional Fed Presidents on and off the voting roster. The Board of Governors is also undergoing some change that means it may be easier for a new Chair to exert his influence.

Bernanke was either heroic in fighting against a strong group of hawks or weak in failing to command authority – either way he didn’t do anything like enough during 2008, especially immediately post-Lehman, and thus caused the Great Recession and paved the way for the horribly long-drawn out “non-recovery”.

Yellen has followed him in not allowing a strong recovery with her constant warnings of a Phillips Curve jump in wage inflation just around the corner acting, Chuck Norris-like, to prevent any such rise or recovery in nominal growth.

While the largely unknown, but apparently dovish, Jerome Powell is favourite to get the job there are still many other candidates. Traders find it hard to locate evidence of the candidate’s actual views or assess their impact on markets.

Surveys vs data

The week continued with the theme we have seen for a while, of surveys, such as the Empire State or Philly Fed, showing robust levels of consumer and business confidence (the NFIB excepted) versus data, such as Manufacturing Output, showing continued sluggish growth and inflation. Manufacturing Output really should have been much stronger if the surveys are to be believed. At least Manufacturing and Industrial Output are now showing consistent if still low YoY growth vs the negative growth in IO and stagnant MO seen during all of 2015 and 2016.

Next week more surveys for October will be capped, at the end of the week by the first, preliminary, estimate of 2017Q3 GDP. Consensus for QoQ annualized growth is at 2.7%, just near where the Atlanta Fed nowcast has ended, at 2.6%, having started much higher. The NY Fed is forecasting a low 1.46%, although its 2017Q4 forecast is back up to the 2.6% trend.

If consensus is right then it would be a respectable rate of growth given the patchy rates seen since 2010 but no recovery and still no hope of regaining previous trend levels – but just how the current Fed likes it.

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