June Fed Preview: what is the Opportunity Money Model saying?
On June 18th and 19th, the FOMC will meet to discuss monetary policy. Similar to the January 2019 meeting, the members of the FOMC are already telegraphing the Fed’s intent on future monetary policy and the markets are responding by pricing in rate cuts.
On 6/4, Fed Vice Chair Richard Clarida said the economy is in a good place but he and his fellow central bankers are willing to take action if conditions change according to CNBC.[1] As well, Fed Chairman Jay Powell went further to calm markets and stoke belief the central bank would cut rates in response to the trade disputes, ““We do not know how or when these issues will be resolved,” Mr. Powell said of the United States’ trade disputes with Mexico, China and other nations. “We are closely monitoring the implications of these developments for the U.S. economic outlook and, as always, we will act as appropriate to sustain the expansion, with a strong labor market and inflation near our symmetric 2 percent objective.”(NYT)[2]
The markets are now pricing in the interest rate cuts. The CME 30 Day Federal Funds Futures contract is now showing in a 50% chance of a 25bp rate cut next week, 100% chance of 25bp by August, almost 100% chance of 50bp in rate cuts in October and almost 100% chance of 75bp rate cuts by January 2020.[3]
Let’s take a quick review of a few economic items the Fed may be considering heading into their meeting.
As an example of the economic impact from the trade wars, the JP Morgan Global Manufacturing PMI shows a steady decline since the US tariffs began in January of 2018.
Continuing on the slowing GDP narrative, the estimates for US Q2 GDP are less than half of the 2019 Q1 3.1% GDP.
Atlanta Federal Reserve 2019 Q2 GDPNow
NY Fed 2019 Q2 GDP NowCast
Note, the Total Business Inventories number on this table as it shows a subtraction from last GDP estimate. I think this is worthwhile pointing out because increases in private inventories helped significantly increase GDP in 2018 Q3, 2018 Q4 and 2019 Q1. The chart below shows the change in billions of dollars.
What’s worrisome here is the average Q1 inventory over this 10-year period is $63 billion and 2019 Q1 was almost double the average. To me, a large inventory adjustment is likely to occur because inventories were built up in anticipation of the 25% tariffs on Chinese goods and inventories are likely to be run down even if the trade war continues. Companies are likely to use the lower cost imports/inventories before ordering new.
Lastly, researchers are anticipating a smaller stimulus from the 2018 tax cuts. The Dallas Federal Reserve compiled a list of academic papers and model estimating the impact to GDP from the 2017 tax cuts. In 2018, they gave us an average 0.98% boost to GDP. In 2019, the estimate is 0.55%. In 2020, the estimate is 0.02% or flat.
In summary, the Fed is likely seeing risks from an extended trade war, a potential sharp reduction in private inventories and waning stimulus from the 2018 tax cuts. The Fed must feel confident that it can risk being more aggressive in discussing rate cuts with inflation below its 2.0% target.
What does OMM tell us?
1. Our financial universe is centered on the Fed as our sun. The markets continue to react to the strongest gravitational pull of monetary policy and this past week underscores its strength. While the Fed hasn’t cut rates yet, the comments and communications are changing the narrative and telling the markets to anticipate cuts sooner than had previously been priced in.
2. Next, US domestic policy (earth) is showing that the trade wars continue to negatively impact the market narrative and create risks. As well, the reduction of stimulus from 2018 US tax cuts will weigh on future GDP.
3. Finally, technology (moon) is impacting the speed of the market volatility with sharp inter and intraday moves. The S&P fell 6.6% in May, but it has rallied 5.1% since. While peak-to-trough drawdowns greater than 5% occur with some frequency, the 11.7% rallies in less than 3 weeks are rarer.
Putting it all together, our planets are not aligned which should generate range trading with a positive drift. The Fed has shifted from “patient” to “taking action” and is creating a strong, positive narrative for risk/stocks. US domestic policy remains negative with no Chinese trade war ceasefire, but a lesser negative due to an apparent immigration agreement over the weekend with Mexico to stave off a 5% tariff. Finally, tech remains pro-cyclical, but we don’t currently have a consistent positive narrative to drive risk to new highs.
[2] https://www.nytimes.com/2019/06/04/business/economy/powell-fed-trade-wars.html
[3] https://www.cmegroup.com/trading/interest-rates/stir/30-day-federal-fund.html
[4]https://www.markiteconomics.com/Public/Home/PressRelease/b2eb8a67afb44a4299eff370169f603e
[5] https://www.frbatlanta.org/cqer/research/gdpnow.aspx
[6] https://www.newyorkfed.org/research/policy/nowcast