Over the last seven years you have probably read countless articles and had endless discussions about when the Federal Reserve (Fed) is next going to hike.
The chart below shows the Fed Funds rate implied by the market at the beginning of each year since 2010. The Fed did finally edge rates higher in December 2015, but the long series of rate hikes continually expected by the market has never come. The Fed’s forecasts of where rates were supposed to go have been even worse than the market’s forecast.
Now that celebrities are starting to get in on the discussion, it might be time to take a look at the other side of the coin: as the saying goes, when your shoe shine boy gives you stock tips, maybe it’s time to sell the market.
The market is discounting a 50 per cent chance of a Fed hike by December, down from 60 per cent a few weeks ago, although it’s still fully pricing in a hike by July 2017, and more thereafter.
But if either the US economy – or perhaps the global economy – continues to weaken, then it’s feasible that the Fed cuts rates next year. This isn’t yet our core scenario, but the market is giving this a near 0 per cent probability, and that looks wrong.
What could lead to a US rate cut?
Risks appear to be mounting, and yet markets are pricing in the opposite, with low levels of implied volatility almost everywhere. There are many global risks on our radar, not least political event risk, the stability of the Eurozone’s financial system, the fallout from the popping of China’s giant credit bubble, and emerging market stresses. But for the sake of brevity, we’ll concentrate here on the risk of a domestic US recession.
Firstly, the high frequency data releases paint a picture of a slowing US economy. The recent ISM report (see chart below) was the weakest since 2009, and we believe this report is the best real-time indicator of economic growth in the US.
But it’s not just the high frequency data releases that have weakened lately. A recent note from Deutsche Bank summarised the topic well, where their economists highlighted four key indicators that are currently flashing red, and have historically been good recession predictors.1) A profit recession. It is worth noting this has been evident for some time now, not only in the US, but also in Europe and Japan.2) A negative LMCI, the Fed’s own Labour Market Conditions Index. This has turned negative again in recent months, and has also turned negative on a 12-month basis.3) Negative capex growth.4) Rising default rates: Moody’s US speculative-grade default rate has risen yet again, to 5.7 per cent. Out of the four occasions in the last 30 years which have seen a meaningful rise above 5 per cent, a recession occurred in three of them.
Deutsche Bank’s research flies in the face of some of the common recession indicator models used by Federal Reserve banks or investment bank economists, which show very low recession probabilities. Many of these models rely heavily on the shape of the yield curve; for example, the New York Federal Reserve’s recession predictor is based solely off the yield difference between three-month Treasury bills and the 10-year Treasury. But I suggest caution when using historical models for interest rate or bond-related forecasting in the current environment. With short-end rates anchored near the lower bound, it is exceptionally difficult to see an inverted yield curve, since 10-year rates would have to fall below three-month rates.
Perhaps the old models are right and we won’t get a US recession until the 10-year yield falls to close to zero. Alternatively, it’s more likely that yield curves have lost some or, perhaps, most of their predictive powers when interest rates are at or close to the zero.
The changing of the Federal Reserve guard
The voting members of the Federal Open Market Committee (FOMC) are made up of seven members of the board of governors, and five of the twelve Federal Reserve Bank presidents. Of the five regional Fed heads, four of these rotate every year, while the New York Federal Reserve governor always has a voting membership.
In September, three members of the FOMC dissented from the decision to keep rates on hold, with Eric Rosengren, Esther George and Loretta Mester voting for a rate hike.
However, all three of these dissenters are non-voters next year. The 2017 FOMC appears much more dovish, as Rosengren, George and Mester, together with James Bullard, are being replaced by Charles Evans, Robert Kaplan, Neel Kashkari and Patrick Harker. Evans is known to be one of the most dovish regional Federal Reserve presidents, and recent communication suggests Kaplan and Kashkari are also on the dovish side.
Market implications of a US rate cut
The US dollar is the clear loser in this scenario. Monetary policy divergence has become a market cliché. This story did play out over the past few years, but in 2016 the US dollar has not sustained its rally. Looking back at the monetary policy divergence story, it seems that we only got half of it: central banks across the world have eased, but the four rate hikes, that the Fed warned us to prepare for last year, haven’t even started yet. A US rate cut, then, would surely start an unwind of the long USD/monetary-policy-divergence trade.
The chart below shows the strong relationship between the Dollar Index and interest rate differentials. Since 2013, two-year US interest rates have diverged by an average of around 120bps from the rates in the UK, Eurozone, Japan and Canada. But central bank rates have only diverged by about 68bps. Much of the divergence in 2-year rates has come from future Fed hikes that never came.
Government bonds rally further. US Treasuries offer some of the highest returns of all developed market debt, and despite the regular calls from bond bears the promised sell-off has never come. A rate cut, especially in a recession scenario, would almost certainly see yet another big old-fashioned bond rally, probably taking 10-year yields below one percent. Government bonds globally should also benefit, albeit to a lesser extent.
Risky assets uncertain. Traditionally, lower US Treasury yields and a weaker US dollar are accompanied by strong returns from risky assets, and particularly emerging markets. However, it depends upon the background to the US rate cut – if the cause of the US rate cut was solely a US-domestic economic weakness, then a risk rally is likely. But if the Fed cuts rates because one of the multitude of global risks materialises, then it is likely that risk assets would be under pressure.
Perhaps then, if one includes the possibility of a US recession or more monetary easing, bond prices do not look so overvalued after all.
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