- 2019 is likely to represent the peak level of interest rates for the U.S. and Canada. The debate among market participants will continue to heat up on whether central banks will succeed in finding the sweet spot in the neutral rate.
- Policymakers will have to double-down on efforts to monitor incoming economic and financial data during this last phase of the rate-hike cycle. High on the watch list will be any sharp deterioration in consumer/business confidence within a slowing global economy.
- There has been some market concern related to a potential stress on commercial banks from the continued draining in excess reserves. Though we believe this is much ado about nothing, the Fed will have to provide clarity on its intention of excess liquidity within the banking system.
- The Bank of Canada has only one policy lever to focus on, the overnight rate. However, the balance of risks for Canada is more to the downside than its U.S. counterpart, given overstretched households and the recent negative shock to local energy markets.
Three years ago, the Federal Reserve raised its policy rate for the first time since the global financial crisis. While it wasn’t the first central bank to hike, previous attempts by others proved premature. For example, the Bank of Canada was one of the first out of the gate, but had to reverse course as weak oil and broader commodity prices dragged down economic growth prospects in 2015.
The Federal Reserve’s cautiousness didn’t go away once they began hiking rates. After a single rate hike, a full year elapsed before another followed, while it assessed the global economic stress stemming from China. Once that risk proved benign, the FOMC re-started the pace of interest rate hikes. Now, with 200 bps under its belt and another 25 bps coming in December, the Fed’s target rate will have entered the bottom end of estimates for the neutral rate (Chart 1). This leaves them facing three important questions in 2019. Will the Fed find the sweet spot within the neutral range, cited as 2.50-3.50%? What will be the interplay of global and financial market movements? And, how will balance sheet runoff be evaluated alongside both of these backdrops? With the exception of the balance sheet question, the Bank of Canada will be facing a similar decision set.
How high will rates go?
The policy decisions of the Fed are directly based on the dual mandate of full employment and stable prices. On the former, the mandate has been filled in a broad sense. There’s no light that suddenly goes off to tell us this, but there are a number of labor market indicators that offer confidence. For instance, the unemployment rate sits at 3.7%, well below the Fed’s 4.5% assumption for the natural rate. Furthermore, the amount of people feeling confident enough to leave current jobs is at a record high, and businesses are consistently reporting increased difficulty in filling positions. Supporting this notion, aggregate wages breached 3% for the first time since the recession. Is there room to draw more workers into the labor force? We suspect the answer is yes. Participation rates of 25-54 year olds are at a cyclical (but not historical) high, and there are about 4.6 million people still working part time for economic reasons. Even so, none of this overcomes from the reality that marginal increases in labor are getting tougher to come by and the data convey a tight labor market.
As wage and other input prices place pressure on the operating costs of businesses, this is eventually passed through to consumer prices. After years of disinflationary pressures, the Fed’s preferred metric of core PCE has largely stabilized around the 2% target rate. There are no alarm bells going off on this front, and recently the trend has even ebbed. But, the balance of risks is tilted to the upside so long as labor markets remain tight and the overall U.S. economy runs at an above trend pace.
Putting all of this into a monetary policy rule tells us that the Fed should raise rates closer to the mid-point of the neutral range, rather than keeping rates at the bottom end. However, this is now the “fine tuning” stage of the policy rate cycle. There is broad agreement that the Fed is within the scope of the neutral level, yet there isn’t agreement on its precise level. That means we will likely see greater diverging views among Fed members (within speeches and voting dissents) relative to the past year, when voices were largely in unison about the direction and pace of rate hikes. Likewise, financial markets will remain sensitive to gyrations in the data and be more “opinionated” on the Federal Reserve’s judgement as peak interest rates come into sight. This is the stage in the interest rate cycle where volatility in equity market movements can become more exaggerated (Chart 2), however this does not necessarily correlate to a downturn in the economic cycle. It’s merely warning shots being fired by investors, as recalibration occurs on expectations for corporate earnings and business cycle risks.
How much do global and financial market risks matter?
With clear evidence that economic momentum has already downshifted in the second half of 2018, the New Year will usher in ongoing questions regarding the stability of the global economy. Ever since the U.S. Administration’s steel and aluminum tariffs, both consumer and business confidence (outside of the U.S.) have eased from elevated levels. More recently, there’s even evidence that U.S. order books are wavering, particularly business sentiment indicators on export orders. Equity and currency markets have indicated their angst (Chart 3), with global markets negative on the year. At this point, 2018 marks the worst year for global equity returns since 2015. The S&P 500 has fared better, holding onto a roughly 4.5% year-to-date return. In turn, safe-haven flows have pushed up the greenback by 8% against its broad trading partners over the year. This narrative is drawing a lot more investor concern and you better bet the Fed is closely watching these developments.
There’s no question that global growth hit the high water mark in the first half of 2018, but this is not a surprise. We had forecasted slower growth, consistent with the fact that momentum was too high relative to its sustainable running speed. However, the knock-on impacts of trade tensions has certainly rung some alarm bells that global growth might now overshoot to the downside, rather than stabilize as we hope. The source of deceleration is largely stemming from emerging market economies. Growth is slowing from Latin America to East Asia. Ground zero appears to be in South East Asia, specifically China, India, and the ASEAN economies, influencing global trade, the commodity channel, and corporate profits. The recent developments from the G20 summit, where an escalation of U.S.-China trade tariffs will be delayed for 90 days is certainly favorable. But, the lack of specifics from both countries and a defined resolution means that the risk-environment remains high.
By the same token, U.S. growth hit a high water mark about three months ago. Although this was a bit later than the global economy due to the fiscal stimulus impulse, momentum is ultimately constrained by the economic fundamentals. GDP growth for the fourth quarter is tracking about 2.5%, down from close to 4% annualized during the previous two quarters. The step-down in global and U.S. growth prospects will leave financial markets more sensitive to gyrations in the data.
It is important to confirm that even though investor confidence is coming down from a cyclical high, we have not yet seen a confidence shock. Advanced economy stock markets typically experience peak-to-trough sell-offs of 15% in any given year. Rec