ECB Versus Fed: A Major Mispricing?

The expected difference between ECB looseness and Fed tightness two years ahead stands near a 20-year extreme.

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We have shown there is no difference between economic growth, inflation, or inflation expectations in the euro area and the U.S. on an apples for apples comparison. And in sharp contrast to the U.S., the percentage of the euro area population in employment is at an all-time high.

ECB President Draghi points out that “the risks surrounding euro area growth relate predominantly to global factors”. If these global risks do materialize, it would prevent both the ECB and the Fed hiking rates through 2018. But if these global risks do not materialize, allowing the Fed to continue hiking through 2018, is it really conceivable that the ECB just sits pat? Our European strategists think not.

The Fed’s “Unhike”

Financial assets rallied, while the dollar declined in the aftermath of yesterday’s FOMC meeting. This resulted in an easing in financial conditions, making the Fed’s actions an “unhike” of sorts.

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The FOMC meeting produced a number dovish surprises. First, the median Fed forecasts still calls for three hikes this year instead of four, as some observers had anticipated. Second, the estimate for the structural rate of unemployment was scaled down further by a tenth of a percentage point to 4.7%. Third, the FOMC statement said that the Fed was looking for a “sustained” return to 2% inflation, while also referring to its inflation target as a “symmetric” one. Fourth, Minneapolis Fed President Kashkari dissented in favor of keeping rates unchanged, which few people had expected.

Having said all this, the market’s reaction still seems rather excessive. The key message from the March meeting was that the Fed now sees inflation as having essentially reached its 2% target. This was reflected in the decision to strip the reference to the “current shortfall of inflation” from the statement. As far as the reference to the Fed’s “symmetric” target is concerned, this is something that Chair Yellen and other FOMC officials have stressed many times before. All it means is that the Fed will not react too aggressively if core inflation were to drift somewhat above 2%. It does not mean that the Fed will purposely try to engineer an inflation overshoot. If it had wanted to do that, it would have lifted its 2019 inflation forecast. It didn’t do that; it remains stuck at 2%.

Why then did the FOMC bothered massaging the language? The answer is that the Fed was probably worried about destabilizing markets. After all, investors were pricing in only a small probability of a March hike just a few weeks ago. A “hawkish hike” could have caused markets to rethink their view that the Fed will “take it slow”. However, now that financial conditions have eased sharply in response to the FOMC’s decision, it is likely that Fed speeches will lean in a more hawkish direction over the coming weeks if the economic data come in firm. Our bond strategists recommend maintaining a below-benchmark duration stance.

EM Growth Scare Before Year End?

If EM/China credit growth decelerates, it will not only cap inflation but also cause a growth scare.

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Given China’s onshore corporate bonds rallied dramatically in 2015-16 on the back of massive investor-buying, a further drop in these bond prices might trigger an exodus of funds and a meaningful push-up in corporate bond yields. In fact, the price of onshore corporate bonds continues to make new lows, and is already down 8% from its peak in November 2015. This could cause corporate bond issuance and other non-bank financing to slump at time when bank loan growth is already decelerating.

Ultimately, higher borrowing costs along with regulatory tightening of banks’ off-balance-sheet operations may cause a slowdown in China’s domestic credit flows in the second half of 2017. This could spill over to other EM economies due to lower mainland imports and declining commodities prices.

In addition, the banking systems in many EMs have not adjusted following the credit boom of the preceding years. Unhealthy banking systems and higher global interest rates will cause further retrenchment in domestic credit creation.

Bottom Line: A renewed slump in China/EM growth later this year will warrant an underweight position in EM risk assets across equities, credit and currencies according to our EM strategists.

U.S. Equities: The Tone Is Changing

Since late last year, the U.S. stock market has started to favor defensively orientated sectors.

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Defensive sectors have troughed at extremely attractive relative valuation levels, based on our models. Conversely, cyclical sectors have rolled over, meeting resistance at very demanding valuation levels of more than two standard deviations above normal.

These nascent trend changes have developed even though the economic data have generally surprised on the upside. This may be an indication that a more forceful response will occur once the string of upside surprises loses momentum. For instance, the global PMI has been very strong, but any hint of a reversal would provide a catalyst for a full-fledged recovery in defensive versus cyclical stocks. Keep in mind that the market is priced for a non-inflationary growth nirvana and even modest economic disappointments could short circuit the buying binge.

Moreover, the 2/10-year Treasury yield curve has stopped steepening and financial conditions are no longer easing. This provides additional confirmation that the defensive versus cyclical equity sector trough is more likely a budding trend change than a pause in a downtrend.

Bottom Line: Evidence of a sub-surface trend change continues to materialize, even in the face of upward momentum in the broad market. Our U.S. equity strategists expect a mostly defensive portfolio structure, along with select interest rate-sensitive exposure, to outperform in the next 3-6 months.

The Fed Has An Itchy Trigger Finger

Despite somewhat mixed economic data, Fed officials are clearly prepping investors for a rate hike on March 15.

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Fed Governor Lael Brainard is the latest official to signal that a rate hike in mid-March has a high probability. What makes Brainard’s hawkish comments particularly noteworthy is that she is well known to have very dovish leanings. She joins Fed Presidents Dudley and Williams, who also raised the prospect of raising rates this month earlier in the week.

The sudden hawkish shift to the Fed’s rhetoric is somewhat at odds with the recent data, which do not call for any increased urgency to raise interest rates. Although the core PCE deflator rose 0.3% m/m in January, our diffusion index fell below zero. This means that the price gains were narrow and it would not be a surprise to see softer price increases in the next few months. Moreover, the annual core PCE inflation rate remained steady at 1.7%, still below the Fed’s 2% target. Meanwhile, a divergence between the “hard” activity data and the “soft” survey data persists. Reflecting the former, real consumer spending contracted in January. Consequently, the Atlanta Fed’s GDPNow model slashed its Q1 growth forecast to just 1.8%. However, the ISM manufacturing survey rose to a boom-like 57.7 in February.

Nevertheless, in light of the recent Fed commentaries, our U.S. bond strategists now believe that a rate hike in March has a high likelihood. It will take a very dovish speech by Fed Chair Janet Yellen tomorrow or a very weak nonfarm payrolls report next Friday to stay the Fed’s hand on March 15.

The U.S. equity market has shrugged off the Fed’s hawkishness. It seems that investors see accelerated rate hikes as a confirmation that the economy is strong. Whether this interpretation is correct or not, investors should keep a close eye on the yield curve. A renewed flattening trend will warn that growth expectations are being marked down, which will make lofty equity valuations more difficult to sustain.