• Risk markets maintained positive momentum in February on expectations of a dovish Fed and a trade agreement between the U.S. and China
  • U.S. economic data trend has slowed relative to expectations in recent weeks
  • January 30 FOMC minutes suggested the Fed may be less dovish than perceived on interest rate policy, but this was largely offset by some surprises in the balance sheet normalization discussion

Risk markets had another strong month in February, boosted by expectations of a dovish Fed and a détente between the United States and China. The S&P 500 is up more than 10% year-to-date, and fixed-income spread sectors are also off to a good start in 2019 following a dismal showing last year. While market volatility has subsided and financial asset performance has improved, domestic economic data have worsened somewhat in recent weeks, at least relative to expectations. Exhibit 1 shows the trend in the Citigroup Economic Surprise Index, and a positive/negative reading indicates that the data, as a whole, were above/below expectations. The sharp decline in mid-February was mostly attributable to a big downside miss in the December retail sales report, and the index is now at the lowest level since August 2017. To be fair, an early-year decline in this index is not unusual. In the current expansion cycle (beginning July 2009), the Surprise Index has fallen to start every year except 2011 and 2017 (eventually declined in Q2 during both years), but with the Fed now voicing a more data-dependent approach, market participants are more myopically focused on such trends.

As noted in last month’s commentary, the January 30 FOMC meeting produced more dovish guidance than expected, particularly as it relates to balance sheet normalization. As such, there was heightened anticipation of the minutes from that meeting, which were released three weeks later in mid-February. The minutes revealed that Fed leaders weren’t quite as dovish on interest-rate policy as initially perceived, but there were some interesting revelations regarding balance sheet plans. For rate policy, the minutes clarified that “many participants observed that if uncertainty abated, the Committee would need to reassess the characterization of monetary policy as ‘patient.’” In other words, another rate hike may be necessary if inflation moves higher than expected or if the economy evolves as currently expected by the FOMC.

There appears to be a more active inflation debate within the Fed, with some concerned that inflation expectations have persistently held below the Fed’s target/goal during the post-crisis era. In a February 22 speech, New York Fed President John Williams encouraged his colleagues to be “vigilant that inflation expectations do not get anchored at too low a level.” Both current inflation data (PCE & CPI) and forward inflation expectations have held at levels well below the pre-crisis period, and it appears that some policymakers are more comfortable allowing inflation to rise above target for a while in an attempt to “unanchor” those expectations.

The minutes of the January 30 FOMC meeting didn’t provide any specific details on the ultimate target size of the Fed’s balance sheet (and appropriate level of reserves), but it did reiterate the preference for ending balance sheet reduction at some point in late 2019. The minutes also confirmed the desire of most participants to maintain only a Treasuries portfolio over the long term. In other words, MBS holdings would continue to roll off, and once reinvestment resumes, those principal cashflows would be redirected to Treasuries. While this isn’t a positive technical for the Agency MBS market on its own, it’s not so simple to assume that this will negatively impact performance in the sector for a period of time.

U.S./China Relations
President Trump entered office determined to end what he considered unfair trade practices by China, including technology transfer and intellectual property theft. The White House’s actions against trade agreements began more broadly last March, initially targeting the steel and aluminum industries, but most observers understood that China was the primary target of trade reform. Tariffs were levied against Chinese goods last year, with threats for more if China didn’t meet certain demands. However, a temporary truce was reached in late 2018 that would halt any new tariffs until March 1 this year while both parties negotiated. Most reports in recent weeks suggest those negotiations have progressed well, with both parties incentivized to reach an agreement. For China, the trade issues have negatively impacted an already struggling economy, and for the White House, the need to maintain positive economic and stock market momentum ahead of the 2020 election is key.

The main issue at this point is agreeing to enforcement mechanisms if the terms of the agreement are breached. As a February 28 Wall Street Journal article highlighted, this is where the previous two administrations had failed in efforts to curb what were considered unfair trade practices by China. The Bush and Obama administrations largely ignored broken promises on the trade front in exchange for support in countering Iranian and North Korean nuclear ambitions, as well as helping combat the global financial crisis and support climate change initiatives. Any challenge of Chinese trade practices was done through World Trade Organization (WTO) rules, which are restrictive.

President Trump so far showed little concern of observing WTO rules, which perhaps makes his administration’s efforts more effective in the negotiations, but the WSJ article suggested that Trump may be more tempted now to settle without achieving “ironclad commitments” from China for structural change in trade practices. The president has already postponed the March 1 deadline, and some are suggesting the desire for continued momentum in the stock market, as well as appeasing U.S. farmers, may be motivating the president to lower his standards for a deal. The next major event in these negotiations is a summit between President Trump and China’s Xi, which hasn’t yet been scheduled (targeting late March). This summit “cannot be allowed to fail” according to Brad Setser, who worked on China trade under Obama and is now with the Council on Foreign Relations...


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