Quarterly Investment Strategy
United States: Fed tightening not a threat (yet) to the economic cycle
Even before (or without) the promised reflationary policies, US economic data is pointing to a step-up in growth.
The Federal Reserve (Fed) moved earlier than anticipated – but this should not be interpreted as a shift to a more aggressive tightening path.
After its failure to repeal and replace Obamacare, all eyes are on the Trump administration’s ability to push tax reform through Congress – at the risk of undermining the market rally.
These days, political noise tends to be overpowering in the US. We urge readers to focus instead on economic data, where most signals are green. The 2014-15 dollar appreciation and concomitant oil price drop are now a matter of the past, enabling the US economy to reaccelerate. Potential corporate tax cuts and a repatriation tax holiday would obviously come as icing on the cake.
Risks to our sanguine US economic outlook are two-fold: higher interest rates, that would drive up the dollar and impair loan growth and housing, and/or potential trade wars, restraining industrial activity. For now, on balance, these risks seem contained. That said, structural demographic and productivity constraints are still very much present, making it very difficult to reach 3% growth even if the Trump agenda can be delivered upon.
On that subject, the failed attempt to repeal and replace Obamacare clearly raises questions as to the ability of the Trump administration to move rapidly and fulfil campaign promises. While it may have no direct bearing on the odds of US tax reform, such is the breadth of Republican consensus on that front, it does make measures lacking a strong support base (such as a border-adjusted corporate tax or the elimination of interest tax deductibility) much less likely to materialize.
As regards monetary policy, we entered 2017 expecting two or three rate hikes over the course of the year. Even though the Fed made its first move earlier than expected, our full-year expectations remain unchanged. The March meeting offered the Federal Open Market Committee (FOMC) a window of opportunity to tighten policy, amid benign market conditions and abating global risks. But we fail to see the rising inflationary pressures that would justify pursuing a more aggressive tightening path. The FOMC seems to be thinking along these same lines, having not altered its projections for the future path of interest rates, inflation or unemployment.
Make no mistake: the Fed is in tightening mode. Measured by the “shadow” Fed funds rate, which incorporates the Fed’s balance sheet, the cumulative hike now amounts to 350 basis points. And for all we know, a 2% or 2.5% rate peak for this cycle will be comparable to the 5.25% peak of 2007 or 6.5% peak of 2000, which were already the lowest peaks for any Fed cycle in at least six decades.
Thus far, though, looking at overall financial conditions in the US, including the shape of the yield curve shown in chart IV, the Fed’s very gradual action does not appear sufficient to bite into economic activity.
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