Despite much headline noise related to political and geopolitical matters, the financial markets remained relatively calm throughout August. The S&P 500 was down as much as 1.8% by mid-month but ended the month slightly positive, and interest-rate volatility, both realized and implied, held near historically-low levels. That said, there are still several potential headwinds that could revive volatility from a nearly catatonic state. This month’s debt ceiling and budget debate is the first. If a budget bill and debt ceiling reset is not passed by September 30, another government shutdown would ensue. Recent projections suggest the Treasury Department could continue using extraordinary measures to pay its bills until October 13. On August 21, Senate Majority Leader Mitch McConnell (R-KY) said “there is zero chance” that Congress won’t raise the debt ceiling. The base market expectation is that a deal will be struck, even if it means a short-term budget extension and debt ceiling lift. The U.S. has never had a technical default on its obligations, despite much theatrics in previous episodes (namely 2011 and 2013), and few, if any, politicians would want to be attached to the first. However, Treasury bills maturity in mid-October are trading at yield premiums of approximately 10 basis points (bps) relative to September and November maturities.
Other headwinds include geopolitical tensions with North Korea, a lack of progress on fiscal reforms, particularly tax reform, and changes in bond-buying programs by the Federal Reserve and European Central Bank (ECB). Regarding the latter, the markets have responded relatively well to the Fed’s plans for initiating balance sheet reduction in the next month. The Fed has been very transparent with its intentions, and the initial pace of reinvestment tapering is fairly benign.
A greater wildcard is the ECB’s intentions with regards to its current QE program. ECB leaders have hinted at reducing or ending the current program, which was tracking at a $70 billion monthly pace over the last four months. Consequently, the euro has rallied nearly 13% versus the dollar since mid-April (see Exhibit 1), and European government bond yields moved higher. European policymakers have seemed supportive of the latter, but the currency appreciation does bring forward concerns related to a potential overshoot (i.e., negative implications for economic growth). As such, the ECB will likely take caution not to sound overly hawkish as it relates to QE tapering, but the general expectation is that purchases will be reduced, beginning in early 2018. If both the Fed and ECB are reducing their presence in fixed income markets, will we finally begin to see steeper yield curves and higher rate volatility? One would assume so in response to increased supply and drained reserves (for U.S. banks), but there are many other variables in play including the inflation trend and demand from global savers.
Geopolitical tensions are another near-term risk for the economy and markets. In addition to firing a ballistic missile that encroached Japanese airspace, North Korea also reported that it successfully tested a hydrogen bomb capable of being attached to an intercontinental ballistic missile. On September 2, President Trump tweeted that the U.S. is “considering, in addition to other options, stopping all trade with any country doing business with North Korea,” which would appear be an attempt to further pressure China to cut off support to the country. While cutting off trade with China is not realistic, the aggressive actions from North Korea may be enough to force China to push harder on its neighbor to the south.
There has been much publicity surrounding the failures of the Trump administration and GOP leaders with regards to healthcare and tax reform, as well as no formal proposals for infrastructure spending. The post-election euphoria in the financial markets (particularly equities) was primarily centered on expectations for tax reform, infrastructure spending, and deregulation. While the first two efforts have yet to materialize in even the smallest way, some are suggesting that progress on the third item has been a quiet success story that could have very positive implications for growth and the markets.
A recent Barron’s article (“Trump’s Secret Weapon: Deregulation”) discussed this issue in more detail, and one of the article participants measured the regulatory trend by tracking the number of pages added to the Federal Register (FR), which is where all new regulations and proposed regulations must be published. Through July 31, the annualized pace of new pages added to the FR was 61,330, which would be a dramatic decline from the nearly 97,000 pages added in 2016. If the 2017 pace held, it would be lowest level since the 1970s, and the year-over-year decline in regulatory actions would be the greatest since the FR was introduced in 1936.
On February 24, President Trump issued Executive Order 13777 “in order to lower regulatory burdens on the American people by implementing and enforcing regulatory reform.” The order required the head of each regulatory agency to designate a Regulatory Reform Officer (RRO) to oversee implementation of regulatory reform initiatives and ensure that those reforms are carried out. For the depository sector, the Treasury Department would review the financial system to ensure regulations of U.S. financial institutions are consistent with a set of Core Principles laid out in a separate Executive Order (13772). The Treasury Department released its recommended regulatory reforms for the financial sector in June, and while the review was in process, it was said that agencies were encouraged to refrain from issuing any new actions. If true, this may explain the record reduction in new regulatory actions thus far in 2017. Nevertheless, expectations for regulatory relief were a major factor boosting business confidence following last year’s election, particularly from small business and community-based financial institutions. Therefore, meaningful reductions in what are perceived as regulatory burdens should be well received by the markets and businesses alike.
What’s Up With Inflation?
The core inflation trend continues to be the most heavily discussed economic theme in the current environment, particularly as it relates to Fed policy and the overall growth trend. The weakness has persisted longer than many economists expected, including Fed leaders, and wage growth remains below average despite years of robust growth in payrolls and the lowest headline unemployment rate since 2001. The official position of the Fed continues to be that the recent weakness is transitory, but the minutes of the July FOMC meeting revealed that “many” participants now see a higher probability that inflation “might remain below 2% for longer than they currently expected.” This conundrum has puzzled many who have held to a Phillips curve principle of unemployment and inflation (inverse relationship). If anything, the Phillips curve has been much flatter than traditional models would suggest, leading to many theories regarding the culprits. Perhaps, more importantly, what will be the catalyst for a sustained increase in inflation rates above the Fed’s 2% target?
Regarding the contributors to below-trend inflation and low, real (or natural) interest rates, some have suggested it is largely a result of corporate consolidation and globalization. In other words, the growth of mega multi-national corporations, particularly in the technology sector, have suppressed wages by reducing the economy-wide labor share, which has contributed increasing wage and wealth inequality (i.e., fewer and more highly-skilled employees). Additionally, these firms have higher profit margins and retain much of these profits as opposed to distributing them as dividends. As such, these firms’ savings outpace investment into capital goods, and they have much of these savings invested in fixed-income, which contributes to lower real interest rates. A recent article discussing this theory suggested three things that could change this trend: 1) a surge in protectionism and de-globalization (reduces the market size for these firms), 2) aggressive antitrust policies, and 3) a change in labor’s collective bargaining power. None of the three would appear to be quick changes, so if this is truly what is required to reverse suppressed wage growth and the overall inflation trend, we may be seeing below-trend price and wage growth for a more prolonged period than many are expecting. This would lead to a lower terminal fed funds rate, but it wouldn’t necessarily halt the Fed’s balance sheet reduction program, which appears more targeted at reducing financial stability risks.
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