Is the Fed ahead of the curve?

Breaking  news: the US consumer is fighting for its life, long live the US consumer. The latest retail sales report from the US was unimpressive, retail sales, when you exclude auto sales and gas, were flat for September, and the August figure was revised down to just 0.1%. This is big news, the US consumer’s appetite for buying is legendary, so why are they stopping now?

The reason is probably the Fed, as consumers give up on spending during the Fed’s rate-hiking cycle. Interestingly, after peaking in May, retail sales have been steadily falling since then. This is a notoriously volatile index, however, if the Fed continues to hike rates at its expected pace (one more hike in 2018 and three further hikes in 2019) then we may see a prolonged patch of stagnant sales as consumers refuse to buy if the cost of credit is moving higher.

This leads us to believe that the Fed’s current path for interest rates could set them on a course whereby they are ahead of the curve, and potentially need to back away from 3 expected hikes next year due to the following reasons:

1, Economic slowdown:

The Citi economic surprise index has been deteriorating this year and is close to its lowest level of the year. The fact that the US consumer is also starting to struggle is likely to be of major concern for the Fed, who won’t want rate hikes to tip the economy into a deep slowdown.

2, The oil price

The Fed does not control the global market place and the rise in the oil price could also hinder its rate hiking cycle. The WTI price has risen some 15% since May, which is a major drag on consumption and economic growth. If oil continues to rise on the back of geopolitical tension and supply concerns, then the Fed may be forced to press the pause button.

3, The Fed’s tolerance for volatility

In the past, the Fed has been accused of acting as a backstop whenever stock markets experienced a protracted decline; do you remember the “Bernanke put” or the “taper tantrum”? Last week saw the S&P 500 fall below its 200-day sma, and the S&P 500 remains 200 points lower than the record high reached on 28th September. The Vix index also spiked to its highest level since March, which is another sign that investors are spooked. If the Fed follows tradition then it will back away from rate hikes, however, if Jerome Powell wants to change tack and not follow the market’s lead, then the Fed may not change course even in the face of heightened volatility and further declines in US stock markets.  This would be a brave move from a Fed chief.

4, Geopolitical tension

The war of words between the US and pretty much every other continent continues. The latest spat involves the US President and its ally Saudi Arabia over the death of a Saudi journalist. This comes on the back of the US trade wars with China. The Fed must be chilled by some of the diplomatic relationships that appear to have disintegrated since President Trump took office in 2017. Usually the Fed can dismiss politics, however when they endanger economic growth then the Fed needs to take notice.

As you can see, these are compelling reasons for the Fed to shift to a neutral as opposed to a hawkish stance at its meeting in December. While we fully expect the Fed to hike interest rates in December, the rate path after that is less clear. There is only a 53% chance of a hike to 2.5 – 2.75% in March 2019, a 34% chance of a hike to 2.75-3% in May 2019 and a 19% chance of a rate hike to 3-3.25% by December, this fell from a 23% chance last week. Thus, further out the curve the market is starting to question whether the Fed will honour its latest dot plot and embark on three further rate hikes next year, with the market majority for a hike in March 2019 only, at this stage.

Why the Fed may not be able to save the stock market

Right now, a less hawkish Fed is manifesting itself in a slight fall in US 10 -Year bond yields, weaker stocks and a weaker dollar. Interestingly, we don’t think that a less hawkish Fed will boost US stock markets in the short term, as the reasons why the Fed might back away from hiking rates three times next year – for example, a weaker economic outlook and rising geopolitical tensions – are all negative for stocks and market sentiment.

Overall, there are growing signs that the Fed’s dot plot from September may be revised lower at the December meeting as the Fed is increasingly getting ahead of the curve.