The stock market rally should not be derailed by Q317 corporate profits, beginning to be reported in a few weeks. The macro evidence suggests another positive quarter, possibly stronger than the 6.0% consensus expectation. To be sure, less favorable base effects could hold down the y/y gain to single digits in Q317, as the strength of profits in Q316 makes for a difficult y/y comparison. A single-digit gain would follow the double-digit pace in both Q117 and Q217, 11.4% and 10.8%, respectively -- the first double-digit corporate profit gain in two consecutive quarters since 2011.
The biggest macro drivers of Q317 corporate profits relate to earnings abroad. Besides economic growth strengthening in Europe and elsewhere, the weaker dollar makes profits earned there worth more in terms of dollars. US Real GDP growth also held up at a good pace on a y/y basis, even though both Fed models have it slowing on a q/q basis (Atlanta Fed model projects 2.2%, NY Fed Model 1.6%, versus 3.1% in Q217).
The macro drags are a slowdown in oil prices on a y/y basis and some squeezing of margins (as prices did not rise as fast as wages -- although the latter did not accelerate).
Markit
Eurozone Real GDP Oil Prices Trade-Weighted
Dollar AHE Core CPI PMI
[ y/y percent
change ] (level)
Q316 1.5 -3.4 2.2 2.6 2.2
Q416 1.8 +16.4 3.9 2.7 2.2
Q117 2.0 +65.3 2.3 2.7 2.2 55.6
Q217 2.2 +13.1 3.1 2.5 1.8 56.8
Q317 2.1-2.2 +6.0 -1.9 2.5 1.7 57.4
Sunday, September 24, 2017
Wednesday, September 20, 2017
Explaining the Markets' Reactions to Fed Tightening
Many market participants, as well as Fed officials, are perplexed at the markets' reactions to Fed tightening -- with stocks up and longer-term Treasury yields and the dollar down. These reactions are the opposite of what traditional theory would imply. In contrast, my "optimal control" approach to understanding the markets explains what has happened.
The optimal control approach says that markets move in the directions that best achieve the Fed's goals. With the Fed stating that it aims for slightly above-trend Real GDP growth and 2% inflation, the markets have moved in pro-growth/inflationary directions. The weaker dollar, in particular, works not only to spur net exports but also to potentially directly lift inflation.
When the Fed tightens -- with the stated aim that it wants to provide room from the zero bound -- the shorter-end of the Treasury curve becomes restrictive of economic activity. As a result, the markets have moved to offset this restrictiveness, given the Fed's economic goals.
The markets' reactions will change if the Fed's economic targets change. In particular, if the Fed becomes concerned about strong growth, the markets will reverse direction -- stocks would fall, longer-term yields rise and dollar strengthen. This possibility is now unlikely. Not only is inflation running below the 2% target, but GDP Growth looks to have slowed in Q317. Both the Atlanta Fed and NY Fed models cut their forecasts of Q317 Real GDP by about 1% point to 2.2% and 1.3%, respectively. As a result, stocks are likely to continue to climb, longer-term yields stay range bound, and the dollar stay soft.
The optimal control approach says that markets move in the directions that best achieve the Fed's goals. With the Fed stating that it aims for slightly above-trend Real GDP growth and 2% inflation, the markets have moved in pro-growth/inflationary directions. The weaker dollar, in particular, works not only to spur net exports but also to potentially directly lift inflation.
When the Fed tightens -- with the stated aim that it wants to provide room from the zero bound -- the shorter-end of the Treasury curve becomes restrictive of economic activity. As a result, the markets have moved to offset this restrictiveness, given the Fed's economic goals.
The markets' reactions will change if the Fed's economic targets change. In particular, if the Fed becomes concerned about strong growth, the markets will reverse direction -- stocks would fall, longer-term yields rise and dollar strengthen. This possibility is now unlikely. Not only is inflation running below the 2% target, but GDP Growth looks to have slowed in Q317. Both the Atlanta Fed and NY Fed models cut their forecasts of Q317 Real GDP by about 1% point to 2.2% and 1.3%, respectively. As a result, stocks are likely to continue to climb, longer-term yields stay range bound, and the dollar stay soft.
Sunday, September 17, 2017
Beyond the September FOMC Meeting
The markets are likely to be little affected by this week's FOMC Meeting. Stocks should continue to rally and Treasuries remain range bound. The meeting's outcome should match expectations of no rate hike but commencement of balance sheet reduction. And, the Statement does not have to change much from July's, except perhaps for some acknowledgement of the temporary drag on the economy from the recent hurricanes. With the Statement likely to keep in place the idea of gradual tightening, the market focus will shift further to the possibility of a Fed rate hike at the December FOMC Meeting. Upcoming wage/price inflation data, however, will probably not make a persuasive case for tightening then.
The combination of no rate hike and balance sheet reduction can be viewed as a compromise between the doves and hawks on the FOMC. A dovish victory would probably require a change in the Statement along the lines of Fed Governor Brainard's views. The Statement would say that the Fed plans to hold back from tightening until it is clear that inflation has moved above 2.0%. This would be a big positive for stocks and result in a steeper Treasury yield curve, helping TIPS in particular.
Even if the doves do not get their way, upcoming wage/price inflation data may very well keep the Fed on hold in December, as well. Although Friday's August Core CPI rose 0.2% m/m, some of the pickup was in rent, which has a smaller weight in the PCE Deflator. So, a 0.1% m/m print for the August Core PCE Deflator cannot be ruled out. It would keep the y/y steady at 1.4%. The Core PCE Deflator needs to average 0.1% per month for the rest of the year to keep the y/y at 1.4% in December. As for Average Hourly Earnings, calendar considerations point to 0.2-0.3% in September (next report), but this would keep the y/y steady at 2.5%. AHE should slow to 0.1-0.2% m/m in October and November. The y/y would fluctuate between 2.4% and 2.5%.
The combination of no rate hike and balance sheet reduction can be viewed as a compromise between the doves and hawks on the FOMC. A dovish victory would probably require a change in the Statement along the lines of Fed Governor Brainard's views. The Statement would say that the Fed plans to hold back from tightening until it is clear that inflation has moved above 2.0%. This would be a big positive for stocks and result in a steeper Treasury yield curve, helping TIPS in particular.
Even if the doves do not get their way, upcoming wage/price inflation data may very well keep the Fed on hold in December, as well. Although Friday's August Core CPI rose 0.2% m/m, some of the pickup was in rent, which has a smaller weight in the PCE Deflator. So, a 0.1% m/m print for the August Core PCE Deflator cannot be ruled out. It would keep the y/y steady at 1.4%. The Core PCE Deflator needs to average 0.1% per month for the rest of the year to keep the y/y at 1.4% in December. As for Average Hourly Earnings, calendar considerations point to 0.2-0.3% in September (next report), but this would keep the y/y steady at 2.5%. AHE should slow to 0.1-0.2% m/m in October and November. The y/y would fluctuate between 2.4% and 2.5%.
Monday, September 11, 2017
No September Fed Rate HIke
Fed officials spoke last week and the bottom line is no rate hike in September. Fed Governor Brainard reverted to her dovish views, arguing even against the hawks' new "medium term" expectation for higher inflation. NY Fed President Dudley took a hawkish view in his speech, making essentially the points discussed in my last blog. But, he tempered his remarks in a subsequent CNBC interview that the hurricanes could influence the timing of rate hikes -- but "that" (sounded like a rate decision) is "probably further out anyway." The commencement of the Fed's balance sheet reduction is likely, however, -- and not impacted by the hurricanes according to Dudley.
Brainard dismissed the idea that transitory factors were primarily responsible for the currently low inflation. Citing the lower inflation in the past year, she said, "a 12-quarter average is typically long enough that temporary factors should not be the dominant concern." She also argued that a ratcheting down in underlying longer-run inflation expectations means that a gradual decline in the unemployment rate will not lift inflation in the foreseeable future -- the argument made by hawks for expecting inflation to rise in the medium term. She said, "Given the flatness of the Phillips curve, it could take a considerable undershooting of the natural rate of unemployment to achieve our inflation objective if we were to rely on resource utilization alone."
Brainard supports the commencement of balance sheet reduction. She said, "A key upcoming decision for the Committee is when to commence balance sheet normalization. I consider normalization of the federal funds rate to be well under way, the criterion for commencing balance sheet normalization. The approaching change to our reinvestment policy has been clearly communicated and is well anticipated." But, she thinks rate hikes are not now advisable. She said, "My own view is that we should be cautious about tightening policy further until we are confident inflation is on track to achieve our target."
Dudley's speech implied that a September rate hike was still on the table. He said, "Overall, the economy remains on a trajectory of slightly above-trend growth, which is gradually tightening the U.S. labor market. Over time, this should support a rise in wage growth. When combined with a firmer import price trend—partly reflecting recent depreciation of the dollar—and the fading of effects from a number of temporary, idiosyncratic factors, that causes me to expect inflation will rise and stabilize around the FOMC’s 2 percent objective over the medium term. In response, the Fed will likely continue to remove monetary policy accommodation gradually."
But, in his interview on CNBC, Dudley pulled back. He said Hurricanes Harvey and Irma will not affect the timing of balance sheet reduction, but could impact the timing of rate hikes. He seemed to suggest that a rate hike decision is not imminent but likely to be later this year. Besides the passing comment quoted above, he acknowledged mixed arguments regarding a rate hike, He said, "In terms of increasing short-term rates, I think it's going to depend on how the economy evolves. On one hand, the economy is growing above trend. That implies that we need to continue to remove accommodation. On the other hand, inflation is below our target, farther below our target than we anticipated, and we also have very easy financial conditions. I think it's too soon to judge exactly the timing of when the next rate hike might occur. But I think the path is clear that of short-term rates are going to move gradually higher over time." He expects US macroeconomic data to be distorted by the hurricanes near term, hurting them initially and then boosting them as recovery takes hold. Although not said, this result could hold back rate hikes for a time beyond September.
Brainard dismissed the idea that transitory factors were primarily responsible for the currently low inflation. Citing the lower inflation in the past year, she said, "a 12-quarter average is typically long enough that temporary factors should not be the dominant concern." She also argued that a ratcheting down in underlying longer-run inflation expectations means that a gradual decline in the unemployment rate will not lift inflation in the foreseeable future -- the argument made by hawks for expecting inflation to rise in the medium term. She said, "Given the flatness of the Phillips curve, it could take a considerable undershooting of the natural rate of unemployment to achieve our inflation objective if we were to rely on resource utilization alone."
Brainard supports the commencement of balance sheet reduction. She said, "A key upcoming decision for the Committee is when to commence balance sheet normalization. I consider normalization of the federal funds rate to be well under way, the criterion for commencing balance sheet normalization. The approaching change to our reinvestment policy has been clearly communicated and is well anticipated." But, she thinks rate hikes are not now advisable. She said, "My own view is that we should be cautious about tightening policy further until we are confident inflation is on track to achieve our target."
Dudley's speech implied that a September rate hike was still on the table. He said, "Overall, the economy remains on a trajectory of slightly above-trend growth, which is gradually tightening the U.S. labor market. Over time, this should support a rise in wage growth. When combined with a firmer import price trend—partly reflecting recent depreciation of the dollar—and the fading of effects from a number of temporary, idiosyncratic factors, that causes me to expect inflation will rise and stabilize around the FOMC’s 2 percent objective over the medium term. In response, the Fed will likely continue to remove monetary policy accommodation gradually."
But, in his interview on CNBC, Dudley pulled back. He said Hurricanes Harvey and Irma will not affect the timing of balance sheet reduction, but could impact the timing of rate hikes. He seemed to suggest that a rate hike decision is not imminent but likely to be later this year. Besides the passing comment quoted above, he acknowledged mixed arguments regarding a rate hike, He said, "In terms of increasing short-term rates, I think it's going to depend on how the economy evolves. On one hand, the economy is growing above trend. That implies that we need to continue to remove accommodation. On the other hand, inflation is below our target, farther below our target than we anticipated, and we also have very easy financial conditions. I think it's too soon to judge exactly the timing of when the next rate hike might occur. But I think the path is clear that of short-term rates are going to move gradually higher over time." He expects US macroeconomic data to be distorted by the hurricanes near term, hurting them initially and then boosting them as recovery takes hold. Although not said, this result could hold back rate hikes for a time beyond September.
Sunday, September 3, 2017
Low Probability of a September Fed Rate Hike?
The markets continue to assign low probability to a September Fed rate hike, as the latest US economic data show little inflationary pressures. But, this expectation is not a slam dunk. The real economy is growing above trend, and some Fed officials appear to be intent on sticking to a path of gradually raising the funds rate as well as beginning to slowly pare back the Fed's balance sheet. Even NY Fed President Dudley expressed this view in an interview a couple of weeks ago. Officials will have a window to make their case publicly in the next two weeks -- before the start of the blackout period ahead of the FOMC meeting. Absent a concerted effort by officials to change market expectations about a September hike, the macroeconomic background will likely continue to support stocks
and keep Treasuries little changed over the next few weeks.
With wage and price inflation remaining low and the Unemployment Rate little changed, a case for steady policy certainly can be made. To be sure, all the evidence is not yet in, as the last important data before the September 19-20 FOMC Meeting will be the August CPI on September 14. Another low print for the latter cannot be ruled out, however.
Although newswires pounced on the slowdown in August Private Payrolls, after a downward revision to July, as a sign of labor market weakening, the two-month average shows a near-trend pace of net job creation (184k versus 185k Q2 average). In other words, the August slowdown could be just payback for the strong July. The underlying job pace actually may be improving, given the downshift in Initial Claims in the past 3 weeks (to 234k on average from 243k in July). Note that BLS is scheduled to release its estimate of the next Benchmark Revision to Payrolls on Tuesday, September 6. This could be important if the estimated revision (in either direction) is large (0.3% or higher).
A number of Fed officials appear intent on sticking to a path of gradually raising the funds rate as well as on beginning to slowly pare back the Fed's balance sheet. There has been a subtle shift in their downplaying the currently low reading on inflation. Besides attributing some of the low prints to one-off price drops, they now emphasize their expectation that inflation will rise to 2.0% in the medium term. In other words, current inflation may not matter in their decision making. In addition, the Fed may want to reach its funds rate target for the year while Yellen is still in charge. Conceivably, she could be a lame duck chair in December if Trump announces a successor to the Fed chairmanship.
The damage from Hurricane Harvey could hold back a September Fed rate hike if only for political appearance sake. But, aside from appearances, the hurricane should not stop the Fed from hiking. Although some macroeconomic data will likely show a negative impact on the economy from the hurricane, including Initial Claims and Payrolls, the drag should be temporary. Rebuilding and catch-up in delayed purchases and hiring will turn the disaster into a positive for growth.
With wage and price inflation remaining low and the Unemployment Rate little changed, a case for steady policy certainly can be made. To be sure, all the evidence is not yet in, as the last important data before the September 19-20 FOMC Meeting will be the August CPI on September 14. Another low print for the latter cannot be ruled out, however.
Although newswires pounced on the slowdown in August Private Payrolls, after a downward revision to July, as a sign of labor market weakening, the two-month average shows a near-trend pace of net job creation (184k versus 185k Q2 average). In other words, the August slowdown could be just payback for the strong July. The underlying job pace actually may be improving, given the downshift in Initial Claims in the past 3 weeks (to 234k on average from 243k in July). Note that BLS is scheduled to release its estimate of the next Benchmark Revision to Payrolls on Tuesday, September 6. This could be important if the estimated revision (in either direction) is large (0.3% or higher).
A number of Fed officials appear intent on sticking to a path of gradually raising the funds rate as well as on beginning to slowly pare back the Fed's balance sheet. There has been a subtle shift in their downplaying the currently low reading on inflation. Besides attributing some of the low prints to one-off price drops, they now emphasize their expectation that inflation will rise to 2.0% in the medium term. In other words, current inflation may not matter in their decision making. In addition, the Fed may want to reach its funds rate target for the year while Yellen is still in charge. Conceivably, she could be a lame duck chair in December if Trump announces a successor to the Fed chairmanship.
The damage from Hurricane Harvey could hold back a September Fed rate hike if only for political appearance sake. But, aside from appearances, the hurricane should not stop the Fed from hiking. Although some macroeconomic data will likely show a negative impact on the economy from the hurricane, including Initial Claims and Payrolls, the drag should be temporary. Rebuilding and catch-up in delayed purchases and hiring will turn the disaster into a positive for growth.
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