Can The Fed Really Risk A Dovish Turn In This Kind Of Environment

By Ben Picton, senior market analyst at Rabobank

The FOMC opted to leave the Fed Funds rate unchanged yesterday with the upper bound at 5.50%. This was expected, so attention turned to parsing the statement and Jerome Powell’s prepared remarks to divine any shifts in the Fed’s reaction function. The economy expanded at a ”strong” pace in the third quarter, rather than the obviously more mediocre “solid” pace that it was previously travelling at. Hawkish!

But lo, we are concurrently warned not to put too much emphasis on the September dot plot, which implies another rate hike. A new set of dots is due next month and the old ones lose reliability with age. Or so Powell tells us.

But what’s in a rate hike? Surely a tightening by any other name would sting as keenly. Quantitative tightening continues apace and the curve has steepened ~86bps since the end of June. Maybe the bond market has done the FOMC’s job for it?

And how much tightening at the long end is equal to one hike at the short end? These are all open questions that Powell says he doesn’t have a definite answer for, but the message that further hikes are a meeting-by-meeting proposition, and that the Fed is sticking with its hawkish bias, is unchanged.

The price action suggests that traders are increasingly sceptical that the hawkish bias will ever be realised. The US 10-year yield fell by 20bps, stocks rallied hard and Brent crude closed below the key $85 technical level. Less dramatic falls in 2-year yields caused the curve to flatten even as the market upped bets on rate cuts next year.

We don’t think the Fed will tighten any further. Our Fed watcher Philip Marey has long suspected the hiking cycle is all over but the shouting. His thoughts on the developments yesterday here.

The Fed wasn’t the only action yesterday. The latest JOLTS and ISM surveys were also released. JOLTS showed job vacancies of 9,553k in September. That’s 56,000 more than August’s downwardly-revised figure, but the clear downtrend that has been in effect since the second quarter of 2022 is still intact.

The ISM manufacturing index suffered its biggest monthly drop in more than a year to record its lowest reading in three months. The 46.7 index number was worse than even the most pessimistic forecast on the Bloomberg survey, and echoes the shabby results in recent days for China, Japan and (worst of all) Germany. So, all four of the world’s leading manufacturing nations are experiencing industry contraction.

In some ways, that is a bit of a surprise. Much has been made of the re-shoring/friendshoring/near-shoring meme, and both Japan and the USA should be major beneficiaries of that. Add in the fact that the USA is running a fiscal deficit somewhere in the vicinity of 6% of GDP, and Bidenomics has provided juicy subsidies for firms looking to manufacture in the USA. Manufacturing should be kicking with the wind.

Census Bureau data shows that annual spending on new manufacturing construction has almost doubled since 2018, but optimism has receded as responses to the ISM survey suggest that the near term outlook is deteriorating. The effects of the UAW strikes are undoubtedly a factor here, but a shrinking forward order book, reduced price pressures and softening employment suggest a broader economic slowdown that could coincide nicely with our forecast of a US recession starting in Q4 of this year.

As it has been for much of the post-Covid era, Canada could again be the canary in the coal mine for the USA. Canadian GDP growth in August was zero for the second month running, and the Canadian statistics bureau is forecasting a similar result in September. If that comes to pass, Canada is in a mild technical recession as growth in Q2 growth was negative.

BOC Governor Tiff Macklem has maintained a similar hawkish bias to the Fed, and is similarly disbelieved by markets. He set tongues wagging overnight when he started to talk about the BOC cutting rates if core inflation started to trend lower (which it isn’t). Jerome Powell says there is no discussion of rate cuts for the time being, but might he start to change his tune early next year too?

Given that fiscal policy is already incredibly expansionary in a time of near full employment, it takes some imagination to forecast Biden increasing the deficit to stave off a downturn. But it IS an election year, and neither Trump nor Biden seem to have any scruples around the budget balance. We don’t think there is any prospect of reduction of guns and butter spending. Neither Biden nor Trump want to take away the butter, and regular readers of this Daily will be aware that we expect that the geopolitical outlook will necessitate much more spending on guns.

Can the Fed risk a dovish turn in that kind of environment? That really would be a surprise.