The Federal Reserve meets on July 31 for its most important monetary enclave in 2019 and will announce a 25 basis point rate cut as “insurance” to hedge the risk of a global economic slump as well as appease the Trump White House and Wall Street. Fed chairman Jay Powell, vice chairman Richard Clarida and New York Fed President John Williams all scrambled to telegraph dovish signals to the financial markets. Yet the latest data on the US economy suggests that the dovish groupthink on the summit of the US central bank’s Mount Olympus is misplaced.
After four rate hikes in 2018 and (guiding the market to expect three more rate hikes in 2019) Jay Powell responded to a 20% meltdown in global equities last January with the most brazen monetary policy U-turn in modern times. The Powell Fed has now guided the financial markets to expect four rate cuts in the next twelve months. This U-turn has triggered an epic speculative mania in assets as diverse as gold (why the $250 an ounce pop in the yellow metal when US inflation pressure is non-existent and King Dollar at new highs against the Euro/sterling), Bitcoin (almost a triple in prices since March), recent IPO’s (Beyond Meat has soared from 25 to 200 in three months) and the S&P500 index (28 times on the Schiller cyclical adjusted price/earnings ratio).
US equities are now 55% of global market cap, the same level as Japan 1989, when the Nikkei hit 40,000 and software shares have never been more expensive (20 times price to sales, if not price to fantasy) amid a collapse in risk aversion. The Volatility Index, Wall Street’s pendulum of greed and fear, has tanked to 12 as the US stock markets have hit all times highs, thanks to Chairman Powell’s misplaced monetary largesse, the latest version of the fabled Greenspan put. So the world faces grave danger on July 31. Why?
The Federal Reserve prides itself as “data dependent”. So let us examine the data since the June FOMC. June nonfarm payrolls were way stronger than consensus at 224,000 and even the July payroll data due next Friday has a consensus of 169,000. The unemployment rate is 3.7%, the lowest since 1969, the first year of the ill-fated Nixon Administration and the Apollo 11 moon landings. The Philly Fed ISM manufacturing data and US retail sales were all a blowout. The US consumer, Joe and Jane Sixpack, 70% of GDP, is on a spending spree, as record earnings from Starbucks, Chipotle and McDonalds, as well as credit card usage data from American Express attests.
Wall Street is optimistic about a negotiated settlement to the US-China trade war. Consumer confidence indices have risen since April. Corporate profits have been resilient and lifted both the S&P 500 and NASDAQ to new highs. Above all, second quarter US GDP was 2.1%, well above the consensus 1.8%. US personal consumption was uber-strong, growing at a seasonally adjusted annual rate of 4.3%. This was confirmed by the 0.3 average hourly earnings in the June payroll data. If truly “data dependent”, the Powell Fed has no business slashing interest rates at this point in the business cycle – au contraire, in fact.
Yet the Powell Fed has whispered dovish sweet nothings to goose the “animal spirits” of Wall Street for the last seven months – and so it must deliver on its rate cut pledge on July 31. The empirical data argues that the Powell Fed should be “one and done”, immediately let the capital markets know that it will shift to a neutral stance after its July meeting, as the Boston Fed President Eric Rosengren dared to publicly suggest.
This scenario, if it happens, will trigger an immediate bloodbath on Wall Street in August and a temper (tweeter?) tantrum by a President Trump obsessed by his own reelection prospects. Gold can well plunge $100 an ounce, the US dollar surge against the Euro above 1.08, the US Treasury yield curve steepen and the yield on the ten year US Treasury note spike to 2.5%, as the trillion dollar daisy chains of high octane borrowed money in the bond market unwind with a vengeance – and take the S&P 500/NASDAQ and global markets down in a spasm of risk aversion last witnessed in early 2016. Is this bearish macro scenario for August credible? Absolutely – if the Fed tells the market that bitter truth that it is “one and done”, that there will be three more rate cuts unless the US economic data deteriorates big time.
If Chairman Powel communicates the truth about no more rate cuts at his post FOMC press conference on July 31, financial markets will price in the equivalent of de facto three rate increases in the next twelve months. Chairman Powell caused a financial market bloodbath by monetary “tough love” tightening in late 2018 – and he could well repeat the same mistake again at the July FOMC if he ignores market positioning. This was the reason it was insane for him, Clarida and Williams to imply that they would even consider a 50 basis point rate cut in July. True, there are storm clouds in the global economy – the risk of a no deal Brexit, the slowest Chinese growth in a generation, credit Frankensteins in the leveraged loan/student and auto debt markets, a potential German industrial recession. Yet the logic of the Fed’s Congressional mandate is clear. Full employment with price stability defined as 2% inflation. This has been achieved and the Federal Reserve should communicate this existential fact to bubblicious Wall Street. Sometimes it is necessary to be cruel in order to be kind.
There is no reason for aggressive interest rate cuts at a time the budget deficit is set to double to $900 billion or 4.5% of the US GDP. However, in the Age of Trump, it will be unwise not to consider the second derivative impact of any Fed “one and done” decision. President Trump will be outraged as a slowing economy could cost him reelection in 2020. So he will opt for the ultimate Presidential quick fix to stimulate the US economy – he will order the US Treasury to intervene in the global foreign exchange markets to bring down the dollar, as Nixon did in August 1971 by ending the Bretton Woods link to gold and Reagan did in September1985 with the Plaza Accords. This act will ignite a currency war with the EU and China but also add to global dollar liquidity if the Fed does not sterilize the intervention in the money markets. Like Japan in the 1980’s, an overvalued dollar is a deflationary force in the US economy and here in the GCC. If greenback intervention happens, all bets are off in the global financial markets as the equations of international finance will go berserk.