Is the Federal Reserve running out of time?

The Federal Reserve was steamrolled by a perfectly hedged move by the POTUS, who escalated the Chinese tariffs conflict, imposing a 10% tariff on 300 bln of Chinese goods. The POTUS and his team decided to further escalated trade wars, after a calculated move urging the FED to cut the IOER by 50 bps during the FOMC July meeting. Since then the market has rallied to long duration trades, which has led to more curve flattening and further inversion of the 3s10y TSY curve. At this point the 2y10y has still not inverted but has come under massive pressure following recent days. Even though long duration trades are not any novelty, due to the fact that financial institutions are chasing yields at every price possible, the sharp decrease in TSY is astonishing.

Generally a flattening of the curve does not mean a downfall for equities. Nonetheless such a flattening emphasizes the fear of escalating trade wars and a Federal Reserve which is not able to communicate its policy in an effective way. The risk of a market correction/downtrend have risen dramatically and market participants are slowly positioning towards a risk-off scenario, with gold slowly but surely crawling back to the levels of the GFC, trading at USD 1502 with no real profit-taking in sight. The aforementioned global tensions are reflected by equities, most notably the S&P 500, who saw a harsh and quick drawdown. The S&P ended up drawing down 205 points, losing 6.78% of its total market cap.

As of recent the distress is also felt in the interbank market with the 3M LOIS widening back to the yearly high, showing a worsening in credit. The move in credit is widely off-set by liquidity constraints, driving towards a wider the EURUSD XCCY basis. This comes as no surprise with the Treasuries decision of increasing the debt ceiling and the earlier than expected stop in balance sheet unwinding. At this moment the XCCY basis is at some sort of a sweet spot. On the one side Europe investors are looking for high yields in the U.S. zone and on the other side U.S. debt managers are looking at tendering low-yield debt. This can be observed by the growth in reverse Yankee funding.

The 5y5y forward rates on inflation levels have come down from the highs off 2.30 to well below the inflation target of 2% set forth by the Federal Reserve. This comes as an aftermath of the slowing in Economic data and the dovishness of most central banks.

The crucial factors which could impact equities are:

1. Forward Guidance of the Central Banks: As other central banks have proceeded to react to growing worries with respect to global trade tensions, like the RBNZ who cut its rate by 50 bps the FED has come under increasing pressure. Fed Fund Futures are pricing in a total of 100 bps cuts up to December 2020. This is not observable in TSY, where the 2Y Yield is trading at 1.5978. If the Fed is unable to put markets at ease ad keeps running behind the curve we could see a correction in equities. In essence, the September FOMC could be absolutely pivotal to resetting animal spirits. The Fed has plenty of excuses to do this, trade-escalations being the primary factor, particularly as Chair Powell has consistently noted that the biggest risks to the economy are those that are external. Nonetheless compared to the rest of the globe US yields are still very attractive compared to other jurisdiction, like the German 10Y Bund who is yielding at -0,587%.
2. Fading fiscal stimulus: With the fiscal easing under Trump, stocks saw an artificial rejuvenation. Since then fiscal stimulus has faded away and makes the comparison of companies earnings rather difficult. This phenomenon could be observed when fiscal easing began an economic surprise was very high, now with fading effects of fiscal stimulus the Citi Economic Surprise Index has been trending lower.
3. Further Escalation in Trade Wars: In the initial rounds of tariffs President Trump raised tariffs to 25% after having levied an initial 10%. This could well become a deja-vu in the newest round of discussions, between the US and CHINA.

As observed by Citi equity markets seem to be essentially trading like a two-factor model, with the input variables Trump Tweets and FED pricing:

1. The end of 2018 brought about more conciliatory tweets from Trump in November but crucially these were unable to prevent the equity market from correcting ~20% due to a hawkishly delivered Fed hike. An almost immediate dovish turn by Powell in conjunction with a friendly Trump tweet reversed the market sell-off at the turn of the year. At this stage, the money market curve hadn’t yet started to price cuts but did price out further hikes.
2. By the beginning of March stocks were up 18% from the December lows, but an abysmal non-farm payrolls number spooked the money markets into pricing an entire cut by the end of the month. Ironically, this is where the “bad-data = good-news” regime emerged. Data weakness gave lower projected discount rates which helped the equity market rally back to all-time highs in May, supercharged by pacifying Trump tweets.
3. The May escalation of trade wars started the vicious circle of the risk assets relying almost entirely on the premise of Fed cuts. The market recovered as ~70bps worth of Fed cuts were priced by June. Sentiment recovered following what looked like a temporary end to trade escalations in the G20.
4. As of now, the Fed has disappointed the market with a ‘hawkish cut’ whilst there looks to be no sight of trade détente in the short term given the move higher in USD/CNH and the subsequent branding of China as a currency manipulator by the US Administration.