Summer has brought with it an opportunity for financial markets to pause and take stock of where things stand in the middle of the year.
Although US interest rates were raised last week, what was expected to be a “dovish tightening” turned in to one with a “hawkish” tilt as the Fed stuck to its forecast for another rise this year and for more rises to come in 2018 and 2019. This was particularly surprising following a run of mediocre economic data causing investors to question whether a further rate hike this year is likely at all.
Adding to the uncertainty are the unfolding events in Washington, which have led to an intensification of the pressure on the US president, Donald Trump, over allegations of Russian collusion and obstruction of justice. Further afield, the snap UK general election has brought Brexit back into focus.
While Brexit and the Trump election were the “dogs that didn’t bark” much in 2016, it may only be from now onwards that the true consequences of these momentous events will start being felt.
In the middle of the year it is usual practice to pause and review where things are, relative to what was expected to happen at the start of it. On the surface, at least, things appear to have gone according to plan, as the Fed has raised interest rates twice so far this year in line with most estimates, as well as with the Fed’s dots. This does not take into account the markets’ reaction, which has led to bond yields tumbling and the dollar sell-off.
The bond market is suggesting that the Fed’s projections for the US economy and for the Fed funds rate are too optimistic. The elevated levels of US equities also speak of forecasts for rate hikes that are not really believed either. While the markets were able to absorb weak growth data in then first quarter as a seasonal phenomenon, they are becoming less tolerant of it carrying over into the second, with inflation remaining subdued and consumption growth weaker than expected.
Not only did the Fed last week stick with its outlook for interest rates reaching 3 per cent by the end of 2019, but it also outlined details of its plan to normalise its US$4.5 trillion balance sheet, saying that it intends to start the unwinding process this year if the economy evolves as anticipated. The tone of Janet Yellen, the Fed’s chairwoman, was also surprisingly dismissive of the recent data softness. Investors are becoming nervous not only about the economic picture per se but also about how political developments in Washington could intersect with sluggish growth to produce a much less rosy outlook, particularly for next year.
While talk of collusion between the Trump campaign and the Russian government was largely dismissed as fanciful in the first months of Mr Trump’s presidency, the firing of the FBI director James Comey in May introduced a greater sense that there may be substance to such allegations. Thus, as the investigations into these issues intensified as a result of the firing, they also widened such that Mr Trump is now being investigated for obstruction of justice.
This would not matter so much if the business of government was carrying on implementing the pro-growth agenda that got Mr Trump elected. But five months into his presidency this is far from the case, with hardly any legislative wins so far to show and questions mounting about whether there will be any in the rest of this year. This already puts the White House in a potentially precarious position heading into 2018, when midterm elections and the special prosecutor’s findings loom.
But it also puts the economy at greater risk of slowing if it is unlikely to get the benefit of major tax reform, regulatory overhaul or a boost from infrastructure spending.
Globally, markets might take some solace from the fact that the economy outside of the US has been performing well. But a surprising election result in the UK – the prime minister, Theresa May, was returned to office without a majority – has revived the possibility of Brexit being a much greater source of instability than was looking to be the case just a few months ago. While Brexit and Mr Trump’s election last year were events that markets were able to absorb surprisingly calmly, it may only be from now onwards that the true consequences of these disruptive events will start being revealed.
Tim Fox is the chief economist and head of research at Emirates NBD.
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