The SEP median forecasts for the next 3 years shows unemployment rates below NAIRU and inflation rates at or below 2%. This implies that the Fed has accepted a long term disinflationary impulse, a flattening of the slope of the Phillips curve, or some combination. This seems right – the modeling work I’ve been doing suggests that we may only get a 1.5% headline inflation rate through the rest of the cycle.
The bigger question there is how it affects the Fed’s risk management perceptions. As it stands, the 5y average inflation rate is just 1.5%, the 30y breakeven is just 1.8%. A lower inflation rate and a lower inflation breakeven rate implicitly limits the Fed’s ability to reflate. With plenty of room for inflation to move above 2% and still maintain a long term average inflation of 2%, one could argue that the Fed may want to keep policy even easier than current projections.
The tightening in financial conditions since June is not yet apparent in the data. We have only seen tentative hints of it so far, such as the very weak Philly Fed print yesterday. The risk is that a weaker string of data over the next couple months causes the Fed to hold off for two more, rather than one more, quarter. Predicated on this, IMO the probability of a Dec vs March liftoff is roughly balanced.
FOMC long run dots dropped 25bps to 3.5%. There is a bit more room, IMO, for it to fall further. This is broadly supportive of my view that fair value for the 30y point is around 3%.
Historical analogs suggest that for equities, we may see one more down move before resolving higher. Historically, instances involving this much technical and sentiment damage take 3 months or so to resolve. Some may interpret it as meaning that a Fed on hold is bearish for equities, but I wouldn’t agree with that, correlations notwithstanding. As I’ve noted previously, the key here is credit. Staring in mid 2014, and partly a result of low risk free rates, investment grade issuance increased sharply. The widening of credit spreads is obviously a risk negative, so optically it may appear that dovish central banks => wider spreads => risk off. But this is not a stable relationship. Credit spreads in some cases are already at recessionary levels. In fact, the last time financial conditions (Goldman’s measure) hit these levels were in 2010, when Fed easing clearly ultimately helped tighten spreads. Now, credit spreads have tightened a bit from the wides, but are still in the process of consolidating. However, if this pause ultimately results in an unexpected jump in issuance, it could ultimately prove a risk negative.
The move in the EUR has taken it near the highs of the year. In addition, 5y5y inflation forwards are now back to levels prevailing at the end of last year. (chart below) The next ECB meeting isn’t until October 22nd, so there could be a lot of changes by then, but the ECB members surely will have a lot to think about in the interim. They’ve already upped their stated limits of purchase sizes, and have been noting that they will do more if needed, so the question is whether that will be the case in a month. Fed Funds futures are now pricing in liftoff in May 2016, so that risk will clearly be discussed by Governing Council members. If US or EU data is weak in the interim, the probability of the ECB expanding QE will be reasonably high, IMO.
The FOMC drove corrections of a number of popular USD crosses and USD related trades. The positioning wash out will probably take a few more days to complete, but this should be a good opportunity to revisit key themes. The delay of liftoff does not change the longer term fundamental trends. A few examples include:
- US growth (and hence eventually higher equity prices)
- European growth (and hence equity prices)
- weaker Chinese commodities consumption (and hence Chinese Capex related assets)
- The very long duration of many commodity supply sources means that the trends tend to last longer than almost anyone expect. A rough 1998 analog suggests further downside, still, for many commodities
- Current Accounts in several EM countries remain unsustainably negative, despite the contraction of domestic demand and hence imports. Many of these countries also have excess debt issues that remain unresolved
The fact of the matter is that we will start to see weaker growth as well as inflation prints following the summer events. Over the past several years, this has triggered easing from central banks globally. There are many reasons to expect a repeat of that through year end. As a result, it is probably dangerous to be excessively short or underweight financial assets in aggregate.