- There was a steady stream of dovish rhetoric from the US Federal Reserve last week.
- Morgan Stanley says that with volatility in markets on the rise, investors are watching intently for any hint of a shift in Fed strategy.
- For its part, Morgan Stanley still expects the Fed to hike rates in December, then twice more next year.
Global investors are on “high alert” for a shift in the policy stance of major central banks, Morgan Stanley says.
It follows a sharp October correction on major stock markets, and recent evidence the global growth story is running out of steam.
More “persistent volatility” tends to “focus markets’ attention on the central banks,” analyst Chetan Ahya said.
And recent comments from committee members of the US Federal Reserve may be reflective of a subtle shift in the outlook.
On Friday night, the Fed’s new vice-chair Richard Clarida suggested US interest rates are edging closer to so-called “neutral” levels — where rates are deemed to be neither supportive or restrictive on the economy.
In view of that, he said the Fed should shift towards being more dependent on key data, rather than holding steadfastly to an outlook of more rate hikes.
Clarida’s comments were the latest in a steady stream of more dovish rhetoric:
- Atlanta Fed President said earlier in the week that current US rate settings are “not too far” from neutral;
- Dallas Fed President said the recent slowdown in global growth is a risk to the rates outlook; and
- Patrick Harker of the Philadelphia Fed questioned the merits of a December rate hike in an interview with the Wall Street Journal.
The CME group’s Fedwatch tool — a probability gauge of future Fed rate moves — now assigns a 65.4% probability of a December rate hike, down from 71.4% in the week prior.
The net result on markets was a steady round of demand for US bonds, while the US dollar got sold off across the board.
However, the “bar is still high” for a drastic change of direction from the Fed, Ahya said.
Morgan Stanley is still forecasting another rate hike in December, then two more next year (March and June).
And that’s largely because a lot of recent data points to robust strength in the US economy.
Unemployment is at a 50-year low, wage growth has “accelerated to a post-crisis high of 3.1%” and the broader US economy grew strongly in Q3. Household savings rates are high while household debt-to-income ratios are low compared to other major economies.
“In that environment, it would be hard to build a fundamental case that the Fed needs to change course quickly,” Ahya said.
However, as the US economy outperforms, things don’t look so rosy abroad.
Both Japan and Germany — the third and fourth largest economies in the world — reported negative growth for Q3, although those falls were partly attributed to one-off factors.
But even excluding those, Capital Economics said Germany’s Q3 growth would only have amounted to a measly 0.1%.
There’s also the US-China trade war, Italy’s debt crisis and Brexit uncertainty — all factors which are weighing on the international outlook.
For evidence of the slowdown, this table from Capital Economics shows five of six key global indicators declined in the September quarter:
CE’s chief economist Neil Shearing said he “wouldn’t rule out an upturn in some of these indicators over the coming weeks and months”.
“But as things stand, it’s difficult to escape the conclusion that the global economy is losing some steam”.
Despite that, Morgan Stanley said the Fed will only consider global developments to the extent they impact the US economy. And while the rate of global growth may slow, it’s unlikely to contract.
So more rate hikes are on the way. And as markets are forced to leave “the warm embrace” of abundant central bank liquidity, investors should brace for more volatility.
“As central banks stay on a tightening path, the ride will likely be bumpy. Like it or not, volatility is here to stay.”