Back in May 2017, when moments after the Fed's latest rate hike stocks soared to new all time highs, Goldman economists found something strange: "surprisingly, financial markets took the meeting as a large dovish surprise—the third-largest at an FOMC meeting since 2000 outside the financial crisis, based on the co-movement of different asset prices." Even more surprising is that according to Goldman, its financial conditions index, "eased sharply, by the equivalent of almost one full cut in the federal funds rate."
In other words, as we noted at the time, the Fed's 0.25% rate hike had the same effect as a 0.25% rate cut, and as Goldman chief economist Jan Hatzius went on to say, this was "almost certainly not" the desired outcome that Janet Yellen had been going after, and that markets had in fact misread the Fed's tightening intentions.
A year and a half later things have changed substantially because as Yellen's replacement, Fed chair Powell, has made abundantly clear the Fed's intentions to tighten enough to slow down the economy are now front and center, and with the Fed Funds rate now above 2% and set to rise above 3% in the coming year, the market is not only paying close attention but is no longer mistaking rate hikes for cuts.
But with trillions in excess reserves still sloshing around the financial system, has the Fed really tightened enough for risk assets to notice (and slide)? Here opinions remain mixed, although what is clear - at least judging by president Trump's belligerent attitude toward Fed Chair Powell - is that the Fed is now willing to sacrifice the stock market and risk assets if it means to get ahead of the curve on its two core mandates: inflation and unemployment.
What does that mean in practical terms? According to a note released by Goldman late last week, the Fed is nowhere near done yet - either based on its dot plot or certainly more dovish market expectations - and "needs to generate a significant tightening in financial conditions to slow the economy to its potential growth pace sooner rather than later." The bad news - for stock bulls - is that "this will require delivering significantly more hikes than priced in the curve."
But wait, hasn't the recent selloff been the functional equivalent of a rate hike from the standpoint of monetary conditions?
To an extent yes, and as Goldman writes, the financial conditions tightening over the last two weeks appears to pose a challenge to the view of even more hikes than priced in by the Fed, as the bank's Financial Conditions Index (FCI) has tightened by 32bp since October 2, despite some reversal over the last few days. The recent stock sell-off was the major driver of the tightening, as shown in Exhibit 1.
Furthermore, when Goldman takes the sum of its FCI and fiscal impulses as an estimate of GDP growth vs. potential, "it seems that we have now seen enough tightening to slow the economy to its potential growth pace as soon as the first half of 2019 (Exhibit 2)."
This is important as it would imply that the Fed would not not need to deliver much more than the 2 hikes that are now priced to slow growth to Goldman's 1¾% estimate of potential.
Yet while an end to the hiking cycle would be great news to bulls, not to mention president Trump, Goldman then goes on to note that it is also the case that the economy is sharply outperforming what would be implied by this approach at present.
This means that while the combined FCI and fiscal impulses imply a growth pace about ¾pp above potential, the actual growth pace is instead about 1¾-2pp above potential, with our Q3 GDP estimate at 3.5% and our CAI at 3.8%.
This suggests that there are other growth-positive forces – e.g. a greater amount of self-feeding momentum – at work beyond the FCI and fiscal impulse as we estimate them.
Goldman then goes on to calculate that about 50% of the current "excess" growth momentum will persist over the next two years, but more importantly, notes that one lesson of recent cycles that will prove applicable to this cycle as well is "that the FOMC has generally thought it prudent to continue tightening until growth has slowed to a potential-like pace", hence Powell's threats to tighten beyond the neutral rate of interest, whatever it may be.
In terms of economic data from the labor market, this would mean continuing the hiking cycle until job creation has slowed at least to roughly its breakeven pace, which we estimate at 100k per month; however with jobs averaging nearly 200K in the past year, the economy’s current growth momentum suggests that these points remain a ways off.
Which brings us to why Goldman thinks the Fed will surprise markets and hike well in excess of the mere three hikes that are priced in until the end of the tightening cycle:
In order to ensure it achieves the growth slowdown we think is needed to contain overheating risks, the Fed will likely still need to deliver significantly more hikes than embedded in current market pricing. As a result, we remain comfortable with our call for 5 more hikes—2 more than priced—through the end of 2019. Under our usual rule of thumb that 150bp in rate hikes is worth 100bp on our FCI, in turn worth 1pp on GDP growth, those additional hikes would result in just enough further FCI tightening to leave growth a bit below potential by end-2019.
This is a problem not only for the economy, which is set to slow down substantially if Goldman is correct, but also for the S&P. The reason is that, as Bloomberg's Ye Xie noted, the stock market is "telling us that the Fed is on the cusp of going too far raising rates." The reason is that the cyclical/defensive stock ratio tracked by Goldman Sachs fell to the lowest since 2016.
That stock market ratio is sliding just as the real-yield continues to move to new cycle highs, reaching 1.1% today.
If the simultaneous rise in yields and cyclical/defensive ratio over the past two years signaled growth picking up, the recent divergence may suggest that monetary tightening is starting to dim the outlook.
In other words, with inflation now steady around 2%, each additional Fed rate increase is a 1-1 tightening of the real rate. And, as Xie concludes, "until the cyclical/defensive ratio settles down, it might be an early sign that investors are starting to entertain the possibility of overtightening by the Fed."
Of course, that assumes 3 more hikes; if the Fed were to hike 5 more times over the next 14 months as Goldman suggests, the outcome for risk assets will be far more dire than the market volatility observed so far as traders realize that - once again - the Fed will simply tighten until something breaks...