The outlook for the economy and Fed policy had been a little murky the past few weeks. A number of things are starting to become clearer, from the Fed, data and news last week:
- The bar for the Fed being spooked by inflation is higher. The Fed went out of their way to put in “symmetric” TWICE in the FOMC statement. This also makes an overshoot less likely. Several Fed members (in particular Dudley and Williams) have come out and said that they are comfortable with inflation being somewhat higher than their 2% target. I think the symmetric discussion probably revolved around: (1) last year’s mobile phone price drops being priced out of the current yoy calculations, (2) the current high oil/commodity prices and tariffs potentially causing a spike in rates, and (3) some members being afraid the yield curve may invert. In any event, this development takes some of the “Fed turning aggressive” tail out of the equation (all other things being equal).
- There are no wage pressures. The Employment Report was “constructive” yet again. However, there do not seem to be any noticeable wage pressures. This is a little surprising since the narrative was that the repatriated corporate earnings would somehow trickle down to the employees. While there is no doubt that some of the elite positions are paying more, it’s less clear about the mass jobs. I took the kids to McDonalds last week, and was surprised to be directed to two large touch screen panels to place my order. This happened at my local bank branch last year. And we are one year closer to autonomous cabs and trucks. I’m not sure how lower-end wages are going to increase with these advances in technology removing lower-end jobs. We are increasingly seeing a divide between the haves and have-nots.
Why do economists keep saying the NAIRU is 5%, then 4.5%, then 4.0% and now 3.5%? The German UR is 3.4% and the Japanese UR is 2.5% and they STILL have no inflation! Rather than rely on statistical models based on past environments, shouldn’t economists just poke their heads out of their shells and look around? I’m not saying I have the answers, but it seems clear the current framework of thinking about employment, wages and inflation is at least partially broken.
- Inflation is not going to be imported from abroad. Data from Europe has been abysmal. If you thought the oil prices, commodity prices or tariff concerns were going to cause a further spike in US inflation or wages, shouldn’t you have seen it in other countries? Does the US operate in some vacuum where only we are affected by raw materials prices? Or are the same (structural) disinflationary pressures that have been present for the past decade, still there? A stronger dollar is also going to be a headwind for higher inflation.
- The tail risk on an Emerging Markets crisis is higher. I was shocked last week when Argentina raised their policy rate to 40%. Those oversubscribed 100 year bonds from last year aren’t looking too hot right now. Add a stronger dollar, and add every “expert” out there suggesting EM was the place to put your money for 2018, and this could have the makings of a larger move.
- Libor-FF seems a bit stubborn to narrow. We barely got 1bp of narrowing in the Libor-FF spread last week. As a result, EDM8-FF widened 2.25bps on the week. EDM8-FF is now only pricing in about 8bps of narrowing in the next 6 weeks. If we don’t get narrow more significantly next week, it’s not clear Libor-FF couldn’t stay wide, with continued Fed hikes and a potential EM difficulties.
- There will be no major trade deal in the US’s favor. I’m not saying this just because the US delegation returned from China empty-handed. The US may get some minor concessions, but there is no need for the Chinese to give us anything more than the minimum. Why? It’s because Trump and the Republicans are facing a “close” midterm election. I put “close” in quotations, because I’m pretty sure they will get killed in the elections, barring some economic miracle. But Trump does not appear to know this. In Negotiations 101, you learn that the side with the time pressure is at a disadvantage. There is ZERO pressure on the Chinese to do anything soon. Is Trump going to crush the global economy by imposing massive tariffs on Chinese goods? Six months before an election? Really? Go for it! For any halfway decent poker player, this is the easiest call ever. So Trump can either: (1) take the trinkets the Chinese were willing to part with anyway so that he can declare a hollow victory ahead of the elections, or (2) blow up the economy and any chance of a positive election. Unfortunately for Trump, having the trade tariffs looming is not going to help companies with their decision-making for the rest of the year. Time is ticking. Sending six of his top aides last week for negotiations just reeked of desperation. It should be no surprise that he got absolutely nothing. There’s really no downside for the Chinese… what’s the worst case scenario? Trump actually imposes tariffs, at which point you just say “oops”
and start negotiating from square one as if nothing happened. Xi is probably cranking up the Rolling Stones’ “Time is on my Side” right about now.
- There is a lot of chatter about this being the end of the business cycle. I’m over my allotted time this week, but perhaps I may discuss this further in a future episode of the CA.
The new insights above lead to some new trade thoughts and more conviction on some old trade thoughts.