Is the Fed Insensitive to Coronavirus Risks -- Mistakes By Fed Officials

The coronavirus appears to be beginning to impact US and global economic activity, at least according to Markit surveys.  Fed officials' comments are not helping the matter for the markets.  For the stock market to recover from the latest sell-off, there has to be good news regarding the virus.  Or, the Fed needs to step in with more contingency-supportive messages.

The coronavirus' impact on business activity is showing up in Markit PMI surveys for February.  European and US manufacturers cited virus-related production disruptions in China as a factor hurting business activity.  The negative influence can surface again in some US data over the next couple of weeks -- Chicago PM, Durable Goods Orders (although there is some positive evidence here, as well), Mfg ISM, and Employment Report.  At this point, the Claims data suggest a smaller m/m job gain than January's +225k.

Fed officials are making mistakes and thereby exacerbating the market impact of coronavirus fears.  In a CNBC interview, Fed Vice Chair Clarida disagreed with the Treasury market's having built in expectations of rate cuts this year.  St Louis Fed President Bullard dismissed these expectations as just a temporary reaction to the virus fears.  These officials emphasized the FOMC decision to keep rates steady, while not tempering it with a promise to act if needed.  More appropriate comments from officials would stress that the Fed is ready to react to significant economic fall-out from the virus.  They also could say the latter is not the case so far.  Both ideas would stem market fears.   Comments along these lines should be watched for in the coming week or so.

By emphasizing the FOMC decision for a steady policy, officials could be repeating the mistake made by Fed Chair Powell in October 2018.  Then, his comments focused on the FOMC decision to hike rates through 2019.  They failed to adequately acknowledge the downside economic risks from the US/China trade dispute.  His comments and mistaken December rate hike contributed to the stock market plunge in Q418.  Both then and now, Fed officials stuck to a rate policy that was not sensitive enough, if not blind, to downside economic risks.

By doing so now, the latest Fedspeak is essentially equivalent to a tightening -- it downplays the probability of an easing ahead.  It runs counter to my prior blog's argument that a steepening of the Treasury yield curve would provide the best signal that a Fed tightening is needed.  By implying the recent decline in Treasury yields is wrong or overdone, as did Clarida and Bullard, officials are claiming to have a better knowledge and understanding of future risks than does the market.   This assumption is particularly dubious given that the extent to which the virus will spread is highly uncertain.

Indeed, having Fed officials promise a "safety net" if needed is particularly important now.  According to an expert cited by Holman Jenkins Jr in a Wall Street Journal op ed piece,  the "next three weeks are going to be critical" with regard to the spread of the virus.  If a global pandemic can be avoided by good policy, the virus' spread should abate as the weather turns warmer and more humid.  But, there is no certainty a global pandemic can be avoided.

The irony of taking an inflexible stance to policy is that the market reactions will be opposite to what officials desire.  In the face of downside risk and little chance of Fed response, Treasury yields will take on more of the burden to address a potential negative impact of the virus on economic activity and fall further -- in contrast to  Clarida's complaint that they were incorrectly building in rate cuts.  The markets take over the task of cushioning the economy.   Treasury yields take on even more of the burden if the stock market declines and dollar strengthens in response to the downside risk.

From a political perspective, the Fed opens itself to the anger of both the Administration and Congress if it does not take an aggressive stance -- at least in its communications -- toward the potential economic harm from the coronavirus risks.  It also could lose the respect of the public.  Fed independence and/or new leadership eventually could be at stake.

 

Good News from China? Fed Policy Too Easy? Bad Idea From Administration?

Developments regarding the coronavirus should remain the markets' focus this week, as not much else is going on.  The latest developments are positive for the stock market.  Policy moves -- another PBOC rate cut and the Finance Minister's promise to provide direct help to companies  -- underscore officials' aim to prevent a big hit to the Chinese economy. 

There is little in terms of US economic data this week.  Perhaps the most important will be the February Philadelphia Fed Mfg Index and the Markit Mfg PMIs on Thursday and Friday, respectively.  They will provide some evidence on the impacts of the virus-induced Chinese slowdown and Boeing 737 Max production shutdown on manufacturing activity.

The risk is that they will show little effect.  /1/ Markit Mfg PMI risks a counter-consensus increase, after the Index missed the Mfg ISM's bounce in January.  /2/  Friday's report on January Industrial Production showed a large drop in aircraft production, implying a 0.3-0.5% pt subtraction from IP by the 737 Max shutdown,   But, this is a one-off subtraction, except for residual effects.  /3/  At this point, the Claims data suggest no significant impact on the overall economy.  Initial Claims are back near their lows and Continuing Claims appear to be catching up to the recent improvement in Initial.

The US economy's strength raises the question whether Fed policy is too easy.  While inflation is not a problem now, will it become one?  Is the easy policy fueling a stock market bubble?  There can be no certain answer to either question.  But, the longer-end of the Treasury market and the dollar exchange rate argue against affirmative answers.  If inflation is likely to be a problem and the Fed is now unresponsive to this risk, the yield curve should steepen and the dollar fall.   Neither is happening.

Arguably, both the yield curve and dollar are reflecting arbitrage from abroad, as monies flow in from countries with weaker economic growth and even lower rates.  But, if that's the case, the stimulus from lower longer-term yields has to be balanced against the drags from weakness abroad and strong dollar.  The longer-end of the market does the balancing, and so far is not concerned about an imbalance toward stimulus.  Looking ahead, a sharp steepening of the yield curve will provide the answer whether tighter Fed policy is warranted.

Until then, the boost to the stock market from low Treasury yields just reflects a channel through which the latter work to stimulate the economy.  If high Price/Earnings (P/E) Ratios serve to block this channel, then yields should fall even more -- thereby justifying even higher P/E Ratios.  What will stop the stock market rally will be evidence that US economic growth has become too strong and inflationary.  We'll know this is the case when the Treasury yield curve steepens sharply.

The Administration's idea of providing tax incentives to persuade lower-income people to invest in the stock market is a bad idea.  It smacks of the pre-Financial Crisis push to include them in the housing boom by having FNMA buy sub-prime mortgages in the secondary market.  Both policies fail to recognize the inherent riskiness of putting people into these investments -- particularly people who cannot afford a large loss.  While a plunge in home prices might have been difficult to imagine pre-Financial Crisis, a drop in stock prices is much more readily imaginable.  Indeed, it is highly conceivable that stocks will rally into the start date of the program and then sell off.

Coronavirus, Powell and US Economy -- This Week's Key Events

Three key items impacting the markets this week  will be /1/ news regarding the impact of the coronavirus on the post-holiday re-opening of businesses in China, /2/ Fed Chair Powell's Semi-Annual Monetary Policy Testimony, and /3/ US macroeconomic data. 

The most important will be news regarding Chinese business response to the virus.  While news reports have highlighted the risk to the global supply chain if Chinese production is severely impacted, there are a couple of reasons why the impact may not be as bad as feared.  The other two items should be market neutral to positive.  Powell will almost certainly repeat the message of the latest FOMC Statement and his post-meeting news conference.  This week's key US economic data are expected to underscore moderate growth with low inflation.

While there is little, if any, sign that the spread of the coronavirus has peaked, there are a couple of reasons that conceivably could prompt Chinese businesses to restart business after the Lunar holiday despite concern about the virus' spread.  One is economic in nature, the other political.   From an economic perspective, Chinese businesses may have to continue operations to generate income to service their high levels of debt.  To be sure, the Chinese central bank's injection of funds last week may be intended to allow banks to loan additional funds to get businesses through this period.  From a political perspective -- and possibly more importantly, the government could view employment of people as a way to prevent widespread civil protest and disorder. 

Fed Chair Powell's testimony to the House Financial Services Committee (Tuesday) and Senate Banking Committee (Wednesday) should adhere to the message found in the January FOMC Statement.  The testimony is meant to reflect the entire Board's views, which the Statement does.  The tone should be market friendly.  The Statement cited moderate economic growth and acknowledged below-target inflation.  The FOMC consensus views the current monetary policy stance as appropriate for the foreseeable future.  But, the risks are still more to the downside than upside.  In particular, Powell said the Fed is monitoring the coronavirus situation closely.  Powell also may mention, perhaps in response to a question, that the Fed is looking at whether it should change its target, such as to aim for a price level (thereby allowing for high inflation to offset earlier low inflation ).

This week's US economic data should not change the picture of moderate growth with low inflation.  Consensus looks for a decent 0.3% m/m increase in January Ex Auto Retail Sales.  And, it looks for a 0.2% m/m increase in the January Core CPI, with the y/y edging down to 2.2% from 2.3%.  Manufacturing Output, within the Industrial Production Report, is seen as 0.0% m/m.  But, the risk is for a slight decline, based on Total Hours Worked for the sector.

The Atlanta Fed model's latest estimate of 2.7% (q/q, saar) for Q120 Real GDP Growth should be viewed cautiously, however.  It seems too high relative to Total Hours Worked and the Unemployment Rate in January, both of which suggest a GDP growth rate closer to 2.0%.  So, the risk is for the model's forecast to come down as more data are released.

January Employment Report Good, But Not Great

The January Employment Report points to a continuation of about 2.0% Real GDP Growth in Q120. While Payrolls were strong,  Civilian Employment dipped and the Unemployment Rate edged up.  Technically, the benchmark revision looks like it did not impact the m/m change in Payrolls after March 2019.  Wage inflation remains subdued.

The +225k m/m increase in Payrolls is in line with the implication of the Claims data that they would speed up from December (+147k, was +145k).  The benchmark revision did not carry through to the m/m changes after March 2019 (the time of the benchmark revision to the level of Payrolls).  The net revision to the m/m changes between April and December 2019 is +92k.  Other revisions, besides the benchmark, likely played a role.

The Payroll composition shows decent gains in most industries.  A stand-out is in Construction, which jumped 44k - mostly in Specialty Trade Contractors (split evenly between residential and nonresidential).  Good weather could have played a role.  However, declines were registered in Manufacturing jobs  (-12k, mostly in motor vehicles) and Retail (-8k, more than accounted for by job cuts in general merchandise).   Early evidence from the Claims data suggest a smaller increase in February Payrolls.

The Average Workweek was steady at 34.3 Hours, not particularly high.  Along with the increase in Payrolls, it resulted in Total Hours Worked rising 0.2% m/m -- putting them 0.8% (annualized) above the Q419 average.  Adding in an estimate of productivity growth points to about 2.0% Real GDP Growth.

The uptick in the Unemployment Rate to 3.6% puts it above the 3.5% Q419 average.  The January level is still historically low, but raises doubts that GDP Growth is above the Fed's estimate of 1.8-2.0% trend.  The Rate should decline q/q if GDP Growth is above trend.  To be sure, this trend estimate may be too low, if last year's stronger Productivity Growth pace continues.

Even with a low Unemployment Rate, wage inflation remains subdued.  Average Hourly Earnings rose 0.2% m/m, putting the y/y at 3.1%, versus 3.0% in December. but within last year's range.

Coronarivus Still a Problem, But Some Positive Developments

Fears of a negative economic impact of the coronavirus should continue to weigh on the stock market, but there were some positive developments over the weekend that could limit the damage.   The apparent success of a Gilead drug on a patient in California is a hopeful development.  And, the Chinese central bank's large injection of liquidity and regulators' actions to restrain stock selling show authorities will try to limit economic damage.  But, until widespread success against the disease is seen, any strength in January and even February economic data may be discounted if not dismissed as temporary.  Once it is apparent that the spread of the virus has peaked, a sustained recovery and rally will proceed.  When this happens, soft economic data will be discounted or dismissed.

This week's US economic data should contain at least some stronger prints, but there are caveats.  In particular, January Payrolls risk speeding up from December's +145k m/m pace, based on the Claims data.  The consensus estimate of +165k is not unreasonable.  However, this report will contain benchmark revisions. And, this revision should cut job growth.

The revision brings the monthly Payroll figure for March of the prior year to the level shown by Insured Employment data.   Bureau of Labor Statistics already has released its preliminary estimate, a large -501k.  (In other words, the level of Payrolls in March 2019 is 501k too high relative to the Insured Employment figure for the month.)  A downward revision in the March 2019 level would cut the m/m trend in Payrolls between March 2018 and March 2019 by about 40k.  This reduction in trend should extend past March 2019.  So, the +176k m/m average since then could be revised down to about 135k.  December's pace would be about 100k.   Note that unless the "spending" data used to construct GDP are revised down, as well, the slower job pace would result in higher productivity growth.  Benchmark revisions to the spending data will be released over the next few months, with GDP incorporating them in the Q220 release, due in July.

The consensus estimate of an increase in the Mfg ISM to 48.5 from 47.2 in December cannot be ruled out.  The decline in the December Mfg ISM to 47.2 seems to be too weak relative to the hard data on Manufacturing Output and Employment for the month.  So, an uptick, like the consensus estimate, is not out of the question.  But, there is no reliable evidence.  Other surveys have been mixed, with none having done a good job predicting the m/m directional change in the Mfg ISM.  On the negative side, the stoppage of the Boeing 737 MAX and global economic uncertainty could hold down the Mfg ISM.  New seasonals also could subtract a bit from the January level while raising December, as well. 

To be sure, the broadest measures of economic performance -- the Unemployment Claims data -- are performing well so far in January.  Initial Claims returned to the low range seen prior to December.  And, Continuing Claims have begun to trend down, although the level is still high.  These data do not show much, if any, deterioration stemming from the Boeing production cutback, global uncertainty, or the coronavirus.  The Atlanta Fed model's first estimate of Q120 Real GDP Growth is 2.7%, seemingly consistent with these data.  Most Street economists look for 1.0-2.3% Q120 Real GDP Growth, according to the Blue Chip Consensus survey.   But, there is very little data upon which to base an estimate.  So, Q120 GDP estimates will likely change as additional data become available. 

If virus-related fears recede in the next couple of days, Trump's State of the Union Address (Tuesday night) and his impeachment acquittal (Wednesday) should prompt a bounce in the stock market.