In recent weeks, the two themes capturing the most attention from financial markets have been 1) the tax reform effort, and 2) the White House nominee for Fed Chair. In addition to fiscal policy (tax reform) and monetary policy (Fed leadership), the narrative could be expanded to include inflation and real growth. These factors provided a boost to financial markets over the last several weeks, but the tailwinds subsided somewhat in late October. The inflation component is really dependent on the other three factors, and while there have been flashes of reflationary pressures in the U.S. and abroad in recent weeks, the consumer price landscape remains mixed (e.g., tepid U.S. PCE report and disappointing Eurozone CPI for September). Domestic real growth has improved, including a better-than-expected initial estimate of Q3 GDP, and it is generally supportive of reflationary expectations. However, the boost from fiscal and monetary policy expectations has waned.
On the tax reform front, the first (and easiest) step was accomplished in mid-October when the Senate passed a budget resolution, which is a necessary procedural step in the legislative process. While this was largely expected, the Senate version included some components that were preferred by House Republicans, which was a somewhat surprising gesture considering the current political climate. As such, the House was able to pass its version of the budget resolution the following Thursday, clearing the way for the much more contentious battle of deciding on the actual components of the bill. This debate will likely center on four primary components: the level of tax rates, the number of rate brackets, deductions, and the deficit impact.
House Republicans are racing to produce their version of the bill this week, and the deficit impact component may prove the most difficult to overcome, particularly within the GOP itself. In order to actually offer the reduction in corporate and individual tax rates initially proposed by the White House and GOP leaders, there needs to be revenue offsets to reduce the budget impact of the tax cuts. The two biggest revenue generators have either been eliminated completely (border-adjustment tax) or cut significantly (state and local tax deduction). A recent Bloomberg article suggests GOP leaders are considering a 5-year phase-in of the corporate tax rate cut, which would lower the overall cost of the tax bill and potentially improve the odds of passage. Additionally, there’s been talk of separating the corporate tax cuts from the individual cuts, which would focus on the former first and save the latter for late 2018 or 2019. Either way, compromise is necessary if something is going to get done in early 2018. If we get beyond Q1 2018 with no legislation, the odds of passing tax reform in 2018 could fall precipitously, due primarily to the mid-term elections later in the year. In other words, it’s difficult to get major legislation passed with Congressional elections looming in the background.
There has been much speculation over the White House nominee for the next Fed Chair when Janet Yellen’s current term expires next February. The presumed candidates are Gary Cohn, John Taylor, Kevin Warsh, and Jerome (Jay) Powell, as well as a re-nomination of Yellen. The first three are perceived to represent a more hawkish shift in Fed leadership, while Powell and Yellen are seen as the status quo picks. Speculation that the Trump administration might prefer a more hawkish candidate pressured long-end Treasury yields higher at times over the last two months, but recent reports suggest that Jay Powell is the leading candidate. His nomination would have a more muted impact on the markets, which may be favored by the White House at a time when stock market performance is being touted (not to mention no needed distractions from the tax reform effort). [Update: Powell was announced on 11/2 as the White House nominee]
The market’s focus on the Fed Chair nomination is perhaps overly myopic. While an important leadership role, the Fed Chair is not omnipotent, and the makeup of the regional Federal Reserve Bank presidents and Fed staff is not expected to change in the near future. This provides greater stability for the FOMC as it relates to the trajectory of monetary policy. That said, a bigger question mark is the makeup of the Board of Governors. In addition to the Chair, there are three open seats on the seven-person board, including the Vice Chair seat that became vacant when Stanley Fischer unexpectedly resigned in September. This doesn’t even include President Trump’s appointment of Randy Quarles to the Board, who was finally confirmed by the Senate in October. All told, Trump could likely end up nominating five of the seven Fed governors in the coming months. This is a historical anomaly considering that the governors are appointed to serve staggered 14-year terms. This structure was created to limit a president to just two nominations per term in an effort to insulate the Fed from political pressures. However, this system hasn’t always worked as plans because most governors don’t end up serving their full term, and over the past few decades, the average tenure has fallen. Because of increasing turnover, the White House and Senate have been slower to fill the open seats, with the exception of Chair and Vice Chair.
This is an unprecedented chance for a president to reshape the makeup of the central bank’s core leadership, but it is still not clear just how Trump intends to utilize this power. The President has touted deregulation as one of his primary initiatives, and the Fed has a big say in financial regulation. Therefore, these choices could have a big impact on the broader economy. As noted though, the nomination process can be slowed dramatically by the Senate, which has to confirm any new appointees. As it stands today, the Fed is engaged in a large-scale policy normalization process, including the unwinding of the extraordinary post-crisis QE programs. Most market participants presume that that the current normalization plans will continue as planned, but the potential change in the Board makeup does present some uncertainty. In the near term, Powell’s nomination would likely suppress those questions for a while at least.
Global Asset Purchases
The Fed officially announced the start of its balance-sheet reduction plan at the September FOMC meeting, and the pace of reinvestment tapering is planned to be very gradual. The European Central Bank (ECB) and Bank of Japan (BOJ) are still actively adding new assets, and there was speculation in the markets in recent months regarding the ECB’s plans for the current QE program that expires in January. The ECB announced those plans following its October 26 meeting, which ended up being very close to market expectations. The program was extended another 9 months, and the pace of purchases was cut in half to €30 billion per month.
With the Fed tapering reinvestments and the ECB reducing the pace of new purchases, the stock of asset purchases by the major central banks will naturally decline over the next year. In fact, the four largest central banks (Fed, ECB, BOJ, and BOE) are on pace to purchase less than $300 billion of securities in Q4, down from nearly $500 billion per quarter earlier this year. That number should decline to just over $100 billion in Q1 2018 and approach zero by late 2018/early 2019 given the expected actions of the Fed and ECB. There has been some speculation that the BOJ may reduce its pace of purchases as well in the coming months, but the landslide victory of PM Shinzo Abe’s political party in a recent parliamentary election may ensure the current pace of purchases for a longer timeframe. Nevertheless, what impact will this decline in central bank purchases have on long-end government bond yields in Europe and the U.S.? For a sustained curve steepening, we will likely need to see strong economic growth and inflation, but the decline in overall market liquidity should theoretically have some impact on term premiums.
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