FED tightening at highest probabilities. What will happen on the markets?

1. EDITORIAL

As highlighted also by the UK research practice Capital Economics “the fate of the US stock market tends to be determined by economics rather than by politics. As a result, it should not be surprising that shareholders have shrugged off both Trump’s recent spat with the judiciary and the various malpractices that are alleged to have taken place in the run-up to the elections.

Admittedly, these events have been compared with two historical “crises”, which were accompanied by much lower equity prices. But those crises – Roosevelt’s attempt in 1937 to appoint more judges to the Supreme Court and the Watergate scandal of 1973/4 that prompted President Nixon to resign – coincided with a recession, which we are not forecasting.

Other key events in US history that have also been labelled political, or even “constitutional”, crises have not tended to have much bearing on the performance of the US stock market either. Instead, equity prices have been influenced by the prevailing state of, and expectations for, the economy. For example, the start of impeachment proceedings against President Clinton in December 1998 did not end a surge in equity prices, which reflected a belief that new technologies had ushered in a faster pace of economic growth.

Nonetheless, economic fundamentals have typically mattered more for equity prices. And we assume that this will remain the case. Our forecast that the US economy will expand at a heathy clip over the next couple of years therefore leads us to conclude that the stock market is unlikely to come crashing down any time soon, even though we doubt that the recent euphoria will last.

The upshot is that we are sticking for now to our view that the S&P 500 will end this year at 2,300, which is only slightly below the current level of around 2,380.

On the back of some positive euro-zone data of late, the German Banking Association (BdB) has called for an end to “the exceptionally strong monetary policy impulse provided by the ECB”. Meanwhile, a Fed rate hike later this month appears virtually a done deal. This might suggest that euro-zone government bonds are vulnerable to changes in monetary policy. Indeed, the BdB noted its concern that “less expansive monetary policy will lead to an overreaction of the bond markets”.

However, we think that such fears are at the very least premature: we do not expect the ECB to raise rates any time before 2019, and think that any spill over from the Fed will be limited. Admittedly, with the exception of the early 1990s, European and US policy rates have been relatively well synchronised.

And in some respects, their economic cycles appear so today: euro-zone inflation, at 2%, is now marginally above that in the US, while both economies have been creating jobs at a decent rate. This might suggest that the ECB will not be far behind the Fed in tightening on the next 9th March mainly for three reasons.

Figure 1: Interest Rates [US vs. EZ]

First, the EZ is set for a minor fiscal tightening. Second, unlike in the US, there appears to be a large degree of spare capacity in the euro-zone and core inflation is below 1%. Third, the possibility of economic disruption caused by the forthcoming euro-zone elections means that the ECB may err on the side of caution this year.

As a result, monetary conditions are unlikely to tighten in the euro-zone. By contrast, we expect the Fed to begin tightening in earnest, causing the yield spread between 10-year Treasuries and Bunds to continue to rise this year (figure 2 shows the behaviour of the US&EUR 10 yrs yield spread).”

Figure 2: US & EUR 10yrs Yield Spread

In addition to the views pointed out above, as highlighted by the asset management house ETF Securities, “another important thing on the FED hawkish behaviour is the investors selling the gold. Following hawkish rhetoric from the Federal Reserve last week, investors changed their view about the timing of the central bank’s next rate move.

The Fed Fund futures implied probability of a rate rise this month went from 40% at the beginning of the week to 90% by the end of the week.

Figure 3: Implied Probabilities FED rate hike

Better-than-expected ISM manufacturing, consumer confidence, durable goods orders and core PCE inflation data released last week was seen to provide the Fed ammunition. A strong reading in this week’s payroll data may give another reason for the Fed to move higher at its March 15th meeting. While gold held steady in the first half of the week amid the burgeoning political risks around Europe, Macron’s announcement of his policy platform unwound part of the ‘fear trade’ as markets cheered on his centrist appeal.
Gold ended the week 1.8% down. We still believe that even if the Fed raises rates this month, elevated inflationary pressure will keep a lid on real interest rates, which will be gold price supportive in the first half of the year.”

Figure 4: Gold price [XAU Index]

Cristian Rusconi

2. DATA TO WATCH

US

• 08th March: MBA Mortgage Applications
• 08th March: ADP Employment Change & Wholesale Inventories & DOE Crude Oil Inventories
• 9th March: Import Price Index MoM
• 9th March: Initial & Continuing Jobless Claims
• 9th March: Bloomberg Consumer Comfort
• 10th March: Change in Nonfarm & Manufacturing Payrolls
• 10th March: Unemployment Rate
• 10th March: Monthly Budget Statement
• 14th March: NFIB small business Optimism
• 14th March: PPI Final Demand MoM & YoY
• 15th March: CPI MoM & YoY & Retail Sales Advance MoM
• 15th March: NAHB Housing Market Index
• 15th March: Crude Oil Inventories
• 15th March: FOMC rate decision
• 16th March: Initial & Continuing Jobless Claims
• 16th March: Philadelphia Fed Business Outlook
• 16th March: Bloomberg Consumer Comfort & Economic Expectations
• 17th March: University of Michigan Sentiment & Leading Index
• 20th March: Chicago FED Nat Activity Index

EU

• 08th March: Trade Balance SA & NSA [FRA]
• 08th March: Industrial Production SA MoM & WDA YoY [GER]
• 9th March: ECB Rate Decision
• 10th March: Trade Balance & Current Account Balance [GER]
• 10th March: Industrial & Manufacturing Production SA MoM & WDA YoY [FRA]
• 10th March: Industrial Production MoM & YoY [UK]
• 13th March: Industrial Production SA MoM & WDA YoY [ITA]
• 14th March: GDP SA QoQ MoM & WDA YoY [GER & ITA]
• 14th March: CPI MoM & YoY [GER]
• 14th March: ZEW Survey Current Situation, Survey Expections [GER & EZ]
• 14th March: Industrial Production SA MoM & WDA YoY [EZ]
• 15th March: CPI MoM & YoY [FRA]
• 15th March: Jobless Claims & ILO Unemployment rate [UK]
• 16th March: CPI MoM & YoY [EZ]
• 16th March: BOE Rates decision [UK]
• 23th March: GFK Consumer Confidence [GER]
• 24th March: Markit Eurzone Manufacturing PMI & Services PMI & Composite PMI [EZ]

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