When I first published the Three Phases model a year ago, one of the things I didn’t anticipate was that the Phases would go in cycles, rather than just be a one-and-done. With the benefit of hindsight, I can summarize the past year in markets with a pretty tight fit to almost two complete cycles through the Three Phases, with distinct events marking each transition from one phase to the next. Most recently, Fed Chair Powell’s remarks on January 4th marked the second Phase 2 to Phase 3 transition of the past year, but if the Three Phases are truly cyclical, then what breaks the cycle and when? Reluctantly, I still feel that risk markets will riot one last time, probably before the summer, and that will force the Fed out of quantitative tightening. However, over the near term I think we’ll get a bit more reprieve from risk-off for reasons related to the way the Treasury spends money ahead of the debt ceiling expiration.
A key underlying premise of the Three Phases Model is that quantitative tightening (QT) is significantly restrictive for the economy. The idea is that asset price inflation reverses under QT, which ultimately affects the economy and the perceived future monetary policy pathway through tightening of financial conditions. Central banks then adjust in response, through dovish course corrections (now plural). Rinse, repeat.
Interestingly and perhaps surprisingly, over the next six weeks or so, liquidity withdrawal in the US is set to pause. Yes, the Fed is still rolling off about $50 billion per month of their securities portfolio, and yes, January 2019 is the first month the ECB is no longer expanding their balance sheet by 15 billion euros per month. However, offsetting this, the US Treasury is about to spend $150 billion more into the US economy than they borrow between now and March 2, 2019. That’s actually a net injection of cash into the economy because the Treasury holds their unspent cash at the Fed in a quasi checking account called the Treasury General Account (TGA). Since that account is held at the Fed and not with commercial banks, when the Treasury depletes the balance, that action resembles quantitative easing in terms of its impact on the money supply and total banking system deposits. This is true regardless of whether the Treasury spends money on wages and salaries or just lets bills mature. The Treasury is required to spend down the TGA at this time because of a codicil in legislation that passed on February 9, 20181, which temporarily suspended the debt ceiling, but prohibited the Treasury from borrowing unnecessary funds during the period of suspension. In effect, the TGA must return to its February 2018 balance before the expiration of the legislation on March 2, 2019. So this liquidity injection will offset the impact of QT between now and then, possibly sooner than later.
I believe liquidity withdrawal is a headwind to risk market appreciation, and equivalently since that withdrawal is likely to be briefly reversed over the near term, I am constructive on risk assets (High Yield, Emerging Markets) over the near term. I’m also relatively constructive on duration because increased liquidity should prevent long end rates from rising too much in a risk-on, and duration provides tape-bomb protection if any of the multitude of macro topics simmering in the background falls over the wrong way.
Once the TGA drawdown and debt ceiling extension are behind us though, I expect the brunt of full-speed QT with now zero offset from the ECB to once again affect markets negatively. That market pressure will likely force the Fed to stop or curtail QT. That will be the ultimate dovish course correction, and the Three Phases cycles will end. Such an action should avert a recession in 2019 and resume strong performance for risk assets.
The recent market turbulence has seen the US money market curve price no hikes this year, and a fair probability of a rate cut next year, whereas our expectation is that the Fed’s tightening cycle still has further to run.
Meanwhile, although European bond markets have also rallied, the ECB and the Bank of England are still priced to hike their policy rates over the next few years. This confluence of pricing cuts in the US and hikes in Europe is unusual, and has not happened since the run up to the 2008 crisis. We think it is unlikely to be delivered, because the importance of the US to the global economy, and to global financial conditions, means that it is difficult for other major economies to tighten policy, when conditions in the US are weak enough to warrant easing.
One way of seeing this is to look at how much tightening was priced for the Fed, when other major developed market central banks started their hiking cycles over the past few decades. This is seen in the chart below, which shows US monetary policy expectations at the start of hiking cycles by the ECB, Bank of England, Bank of Canada and Reserve Bank of Australia since 1994. Of the 24 hiking cycles shown below, there were only three instances when the central bank hiked without at least one hike priced for the Fed. Each of these episodes was in the lead into the financial crisis, which the US money market curve was by that time anticipating. The Bank of England and Reserve Bank of Australia, which started tightening in 2006, did manage a series of hikes before the crisis struck, whereas the Bank of Canada, which started tightening in 2007, had to reverse course quickly.
Another way of showing this is to look at US growth forecasts, at the start of these same developed market central bank hiking cycles. Again, there have only been two instances when other major DM central banks hiked, when US 1-year-ahead growth forecasts- currently around 2.5% – were below 2%. Of these two instances, the ECB in 2008 had to reverse course almost straight away, while the RBA in 2009 was the exception that proves the rule, and did manage a series of hikes.
The upward-sloping money market curve in the Eurozone is in some sense mechanical. The ECB’s current policy rate of -0.4% is perceived to be around the effective lower bound, and if further easing is off the table, the market is obliged to price a skew towards higher policy rates. Also, negative rates represent emergency policy in what are no longer emergency conditions, and the change in ECB leadership later this year could prompt a change in the policy stance.
Against that, very little in the current Eurozone data flow argues for tighter policy. Granted, the labour market has shown strength, with unemployment still falling to the lowest in a decade, and wages rising solidly. But Eurozone growth has been weakening steadily for a year, and underlying inflation is showing little or no upward momentum.
For the UK, Brexit remains the key swing factor for both the economy and monetary policy. If Brexit uncertainty abates materially in the next few months, then unemployment at the lowest rate since the 1970s and rising wages point to further rate hikes from the Bank of England. But this too would require a supportive global environment – if the Fed is knocked off course, other central banks will be too.