Divided they fall

Tracey McNaughton

Escala Partners

As expected, the US Federal Reserve opted to cut official interest rates by 0.25 percent this week taking the rate down to 2.0 percent. In the press conference that followed, Chairman Powell said that the cut was sufficient for now given the health of the US economy but the Fed “is prepared to be aggressive (in cutting rates further) if growth were to falter.” The equity market took some comfort from this.

The most interesting aspect of the meeting was the level of dissent among the voting board members. The last meeting saw two out of the ten voters dissent. This meeting saw that number rise to three. Two voters wanted no change in policy and one wanted a larger cut (0.5 percent) in interest rates. The level of dissent is not only reflective of where we are in the economic cycle, but also of the additional level of uncertainty the Trump White House has introduced.

The Fed’s reaction function

Most economists and investment strategists are familiar with the need to interpret the Fed’s “reaction function”. That is, discerning how the interest rate setters will respond to the flow of economic data and events.

This has been difficult at times. Alan Greenspan, who served as the Chairman of the Federal Reserve between 1987 and 2006 (second longest tenure of a Fed Chairman) was famous for his obfuscated language. He once said: 

“I know you think you understand what you thought I said but I'm not sure you realize that what you heard is not what I meant.”

Successive Chair’s have sought to address the communication issue and moved the Bank to a more transparent position. Today we receive minutes of the policy meetings and forecasts of where each member of the board expect interest rates to be in the future. This has helped to shed light on how the Fed thinks and therefore how it will react to events and data.

Data-dependence is a term used often by the current Federal Reserve. On this basis, given the relative robustness of the US economy, it is difficult to argue why we needed a rate cut at all this month. Inflation, excluding the volatile food and energy components, is sitting at an 11-year high. The labour market is tight with the unemployment rate bouncing around its lowest rate in 50 years. Consumer spending, which makes up 70 percent of the US economy, is healthy.

So on the basis of data-dependence, the case for a rate cut is slim. Add to this the concern that the Fed would like to preserve as much monetary fire-power as possible to avoid the situation Europe and Japan face with negative bond yields (Chart 1.).

Chart 1: Amount of negative yielding debt by country and type ($ trillion)

Source: Bloomberg

This goes some way to explaining why we saw so much dissent among the voting members.

There is more to the Fed’s reaction function than this, however. The data is slow in being released and is prone to revision. Historically, the economy has been in recession well-before if appeared in the data.

Another complication to being data-dependent is the lag involved in policy taking effect. Typically, a change in interest rates by a central bank takes 9-24 months to be fully effective. This necessarily implies policy makers need to be forward thinking.

Weight of uncertainty

This is where it becomes difficult. While exports form a relatively small part of the US economy (just 12 percent compared to 47 percent for Germany), the ongoing trade dispute between the US and China is causing uncertainty leading US business investment to either be delayed, or denied altogether. In general, companies that are domestically-focused are doing well. Companies that are directly, or indirectly, associated with trade have to confront this trade uncertainty. We have seen manufacturing activity in the US begin to contract and business investment is now shrinking (Chart 2.). This in turn is pulling down the potential growth rate of the US economy.

Chart 2: US Nonresidential business investment

Source: Bureau of Economic Analysis, JPMorgan Chase

The weight assigned to this uncertainty helps to inform how the US economy is viewed. James Bullard, the third dissenter in the meeting was pushing for a 0.5 percentage point cut in interest rates because he assigns a higher weight to the impact of trade uncertainty on the economy. Other voters on the Committee are less concerned, preferring to look through it.

A second reaction function

Complicating today’s environment, is a second reaction function. This one comes out of the White House. In today’s environment, how President Trump will react to news and data has become increasingly important. JP Morgan has even created an index (called the Volfefe Index) that tracks the market impact of Presidential tweets. The tweets have significantly increased volatility in the market and has helped cause a gap to open up between market pricing and economic fundamentals.

The challenge with trying to discern the Trump reaction function is that it is not stable; it is not necessarily rational; and it exhibits interdependence. Arguably the key variables that the President focuses on most are interest rates, trade, and the equity market. All three are inter-related. President Trump could potentially force interest rates lower by escalating the trade war with China. This will then effect the equity market which in turn may elicit a further reaction from the President.

We have seen this before. A recent example was the tweet in May to impose tariffs on Mexico. This was quickly reversed just one week later as it had such a negative impact on the equity market.

Sense and sensibility

How should an investor respond to a market that is exhibiting excessive sensibility around the Trump reaction function instead of focusing on the rational endowments of the Fed’s reaction function? We continue to focus on the need to be diversified in this environment. Building a portfolio that is built on a foundation of many different risk premiums – equity, interest rates, credit, alternatives – will provide some level of stability against the unexpected market move. Secondly, thinking in decades rather than days helps to look through the noise. Finally, avoid taking high conviction positions. The risk/reward ratio is no longer present.

Tracey McNaughton
Chief Investment Officer
Escala Partners

Tracey was appointed Chief Investment Officer at Escala Partners in November 2019. In this role she has responsibility for strategic and tactical asset allocation and manager selection across all multi-asset funds, and is Chair of the Escala...

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