Markets to Fed: Slow Down – Central Bank Policy Risk Rising

After a brief stock market surge following the midterm elections (gridlock in Washington is viewed as positive for markets), optimism was vanquished by pessimism. The dark clouds of a sterile FOMC statement and the grim news that oil has entered a bear market contributed to this shift in outlook. The intraday chart below shows the S&P 500 for the week – note the gap up after the election. Look for the circle on the graph on Thursday 11/8 – this is near the top of the week’s trading range (Chart 1) and coincident with the 2pm Thursday FOMC release.

Investors hoped the FOMC release would include some reference to October’s equity slump, and a hint that a steady stream of rate hikes might not unfold like the dot plots. Markets hoped for language that suggested a monetary pause that refreshes might be in the cards – no such effervescence could be found in the FOMC Release. Not only did stocks fall, but oil entered a bear market this week (Chart 2). Oil is racing towards a 50% retracement of the rally that began in 2017. This should be positive for the economy (like a tax cut) and offset some of the impact of Fed tightening. At the same time, it should make the Fed rethink the speed of its tightening cycle. Inflation expectations are falling again towards the bottom of the TIPS 10-Year Breakeven trading range that we have highlighted in recent bulletins (Chart 3). It does not matter if oil is falling in price due to supply, or commodity markets are flashing warning signs about growth. Either way, we expect it to drag down the rate of inflation below the Fed’s 2% target. If this happens, the Fed tightening cycle will contribute to disinflation at the wrong time in the economic cycle. Given US deficits and concerns about rising private sector debt and rising Federal debt levels, this is a real problem. It is equally disconcerting that the US dollar bounced back up to the top of its trading range (Chart 4). As we noted recently, if the US dollar melts up, and the TIPS market expectation for inflation breaks down, expect more trouble. The economic data has been strong, but animal spirits are darkening again.

While the 2/30 year Treasury slope had broken its down trend several weeks ago (Chart 5) and began to steepen (positive for growth and rising inflation expectations), in the past couple of days that trend has begun to reverse and is sitting on the upward trend in place since September. We expect it will bode poorly for markets if the flattening trend begins again in earnest.

All of these charts suggest that risks for a central bank policy error are rising if the tightening cycle continues to unfold as planned.

S&P 500

OIL PRICES

10 YEAR TREASURY

U.S. DOLLAR

2/30 YEAR TREASURY SLOPE

Source: Bloomberg, accessed on November 9, 2018

– Jonathan E. Lewis, Chief Investment Officer

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The Standard & Poor’s 500, often abbreviated as the S&P 500, or just the S&P, is an American stock market index based on the market capitalizations of 500 large companies having common stock listed on the NYSE or NASDAQ.