All eyes are on Fed Powell this Wednesday, as he chairs the March FOMC meeting. What a difference a few months make. The last time he chaired the FOMC, the S&P 500 was holding on to 2400 for dear life. Powell threw the markets a life line, suggesting the Fed would be on hold, given the risks faced by the economy despite a solid, robust outlook; classic goldilocks (good growth, low inflation, accommodative policy) statement. The dollar fell and the market cheered as it saw evidence of the Fed put firmly in place.
We are now back at 2820 and the worst of the December chaos is behind us. With markets back to all-time highs, labour markets showing strength and core inflation indicators picking up, does Powell still have enough ammunition to stay on hold? If so, he would be stoking the biggest inflation overshoot by not removing the liquidity opioid addition investors are used to, further fuelling the economy into a recession later down the road.
The market confuses the fate of the Fed's interest rate increases and balance sheet normalization process with the Trade War resolution. There is no doubt a connection at a very deep level.
If Trump decides to wage war against China economically, and stays stuck on getting a deal on his terms only, then we could get a repeat of the fourth-quarter selloff -- and Fed Powell knows that all too well. But if Trump is close to engaging in a deal with China, which seems to be the case, as he appears to be losing a lot of political capital with his trade games, then Fed Powell can go back to his day job and rid the economy of the excess liquidity in place since 2009.
Since the trade talks have been postponed yet again, the Fed is going to face some serious questions as to why it should stay on hold despite financial assets back to more healthy levels. The key is to watch the dollar, as the Fed officially still models about 1-2 rate hikes this year, where most assume 1 rate cut in 2019. There is a big disconnect that needs to be resolved. With any inclination towards the Fed keeping its hawkish stance, the dollar will rally and markets will come off their lofty levels. If the Fed moves its dot plot lower, signalling a rate cut in any way, the markets will not be pleased either, as they might wonder why there is a need to do so.
Buybacks have been a big driving force for the market rally in 2018 and 2019, as corporations have been a big part of the buying flow. However, if you look at the index that tracks insiders, they have actually been selling on this bounce since December. There is usually a very good correlation between this measure and the S&P 500, albeit with a bit of a time lag, but it does not bode well for the future performance.
If one were to focus just on the "hard data" in Q1, it is showing a sharp deterioration in GDP during this quarter. The bond market's performance also rings alarm bells, given the percentage of yield curve inversions is now closer to 45%. The previous times when there was such a disconnect between credit, bond and equity markets, the latter began to fall shortly after.
We all know the rally is built up on aggressive central bank stimulus injection in January mixed with some sort of resolution between the U.S. and China, even though -- other than purchasing a few extra goods from the U.S. -- nothing has fundamentally changed. One needs to keep an eye on the Chinese yuan. All this monetary and fiscal stimulus aside, the yuan should be trading lower, not higher. China can't have it both ways with markets up and yuan too. The U.S. twin deficits are getting worse, implying the upside for equities is capped.
If the yuan starts falling aggressively, this will have negative implications for commodities -- including copper, iron-ore and oil, as well. This year factor investment funds have underperformed, as the correlation of asset classes is close to 1. Market neutral funds are underperforming, as there is just one trade here, everything up or everything down -- the macro trade!
When fundamentals and economics do not align with liquidity, it is best to take a breather and wait on the sidelines than be caught long and wrong. No matter how hard it is to see it moving higher every day, it is best not to get sucked in.
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