Rick Rieder and Russ Brownback argue that slowing growth, peaking inflation and tightening financial conditions combine to make a strong case for a Fed policy rate hiking pause in early 2019.
If you’ve ever endeavored to furnish a new dwelling, chances are you’ve faced the daunting task of installing a large wall fixture, perhaps a mirror or painting. The dreaded process entails extensive choreography with multidimensional measurements, access to the requisite tools, and a willingness to embrace the reality of numerous unsuccessful attempts and unsightly holes in your living room wall. Eventually, after wrestling your fixture onto its hook, you need to step back from the wall for a better perspective–a pause in your process to ensure that your laborious undertaking has achieved an optimal outcome. To us, the Federal Reserve’s ongoing efforts to seek policy neutrality are a similarly painstaking and imprecise exercise, and that recent market tumult, alongside a deceleration in growth and inflation, provides sufficient reasons for the Fed to step back and ponder their efforts to date before acting further.
The evolution in global liquidity
Conventional wisdom says that 2018’s market contagion is unjustified relative to the de minimis absolute level of cyclical policy tightening relative to history. To us, it’s not the absolute level of tightening that’s causing consternation, but the stark contrast of today’s aggregate policy posture versus this time last year. In the fourth quarter of 2017, global liquidity was growing at its fastest pace ever: developed market real policy rates were negative, China was enjoying the tail-end of a multi-year credit explosion, and the U.S. was set to unleash powerful fiscal stimulus, a global policy cocktail that was perhaps amongst the most supportive postures of recent years for risk assets (see graph).
Today, global liquidity is in steady decline, U.S. real policy rates are the highest levels in almost a decade, China is endeavoring to deleverage, and U.S. fiscal stimulus is set to abate. Moreover, U.S. Treasury supply has doubled from last year. This sudden policy U-turn is creating a two-fold systemic shock to the financial economy: the newfound availability of positive real-yielding risk-free securities, along with the significantly higher discount rates that need to be applied to risky cash flows, are crowding investors out of risky assets.
Many financial prognosticators stubbornly adhere to a forecast of significant additional policy tightening, even though markets are increasingly loath to price in that hawkish path. At this point, at least, we agree steadfastly with the markets and hold the view that we’re at the doorstep of policy neutrality and a Fed pivot toward a more symmetric, and data-dependent, forward policy path is at hand.