Tightening conditions to end Fed cycle - and soon

Investor sentiment turning sour

(The opinions expressed here are those of the author, a columnist for Reuters — Editor.)

URises

By Jamie McGeever

S financial conditions are tightening, a potent mix of a strong dollar, weak stock markets and flat yield curve squeezing the availability of global money that will bring to an end the Fed’s rate-hiking cycle sooner rather later.

By some measures, conditions are tighter now than they have been for years and money markets are reacting accordingly. A rate hike later this month is no longer the nailed-on certainty it had been, and even one single quarter-point increase next year is no longer fully discounted.

The more financial conditions tighten, the less the Fed needs to raise rates. Fed officials, including Chairman Jerome Powell himself, are beginning to strike a far more cautious note on how much further rates will rise.

Goldman Sachs’s financial conditions index has risen by about 80 basis points since early October, and is now its highest in two years.

That’s a “material but far from devastating” rise, the US bank’s economists reckon. But if conditions stay as tight as they are currently, US GDP growth over the next year could fall by as much as 1 percentage point, they warn.

Goldman is among the most hawkish houses on Wall Street, but is now rowing back. It no longer expects the Fed to raise in March, and now sees three rate rises next year instead of four.

According to the St Louis Fed, financial stress is its highest now since April. It’s not quite at February’s peak, but if it does scale that - and you wouldn’t rule it out - the index will reflect the greatest degree of US financial stress in seven years.

The wall of worry investors are now climbing has been there all year. It’s just that they’re climbing it now, whereas they hadn’t before. A brewing USChina trade war, rising US rates and yields, slowing corporate profit growth and the economic expansion getting closer to rolling over are taking their toll.

Fed officials will be reluctant to slow the pace of policy normalization if they can help it because that would confirm the suspicion that the “Fed put”, the idea that markets will be bailed out with rate cuts at the first sign of trouble, is still very much in place.

They may have no choice though.

Wall Street is on the slide, and investor sentiment is turning sour. The S&P 500 just had its worst week since February’s “volmageddon” selloff, losing 4.6 pct, the tech sector is creaking, both investment and junk grade credit spreads are widening, and recession warnings are flashing.

The 2s/10s yield curve got to within 10 basis points of inverting last week. Parts of the curve at the shorter end, like the difference between three- and five-year Treasury yields, have already inverted.

Reason

Every one of the last seven US recessions has been preceded by the two-year yield falling below 10-year yield. It looks like the curve will invert again soon, another reason markets are seizing up.

A flattening and inverted curve hits banks’ profitability and willingness to lend. It goes without saying that when the availability of credit for households, businesses and investors dries up, the market and economic consequences can be severe.

The US economy has been remarkably stable this year, impervious to the deterioration across much of the rest of the world. But that may be changing - the housing sector, usually an accurate gauge of where the wider economy is headed, is looking fragile.

The rest of the world doesn’t have its problems to seek. Emerging markets are buckling under the weight of a strong dollar, the eurozone is growing at its slowest pace in over two years, Germany’s economy contracted in the third quarter, Japan’s economy shrank at an annualized rate of 2.5 pct in Q3, and Britain is being battered by Brexit chaos.

On top of that, China, the engine of global growth for the past 15 years, is growing at its slowest pace in a decade.

Powell has yet to follow his predecessor Janet Yellen and suggest that the Fed is taking into account global conditions in its policy discussions and decisions. That may change soon too. (RTRS)