Macro & Markets

U.S. cyclical momentum reaffirms the Fed’s mission


In Brief

Macro Implications:

  • A firming in U.S. wage growth and consumer prices combined with healthy domestic spending and expansionary fiscal policy should keep the Fed on its quarterly tightening course
  • In our view, the risks surrounding Turkey and emerging markets more broadly are not likely to derail the Fed, but could stall the ECB for longer than previously anticipated, as Eurozone banks are more exposed to the challenges in Turkey

Investment Implications:

  • The U.S. macro backdrop remains healthy and that is precisely why the Fed is continuing to tighten policy. Yet, we would caution that the link between macro and markets is not as straightforward as it was in prior years
  • Earlier in the cycle, market returns outpaced economic growth, but going forward it’s likely to be the reverse. To be sure, we still expect positive returns in risk markets for the remainder of the year, primarily driven by secular growth in tech and healthcare
  • Higher U.S. yields and elevated uncertainty abroad will likely limit near-term weakness in the U.S. dollar
  • We expect the spread between 2– and 10-year Treasury rates to continue to narrow and reach zero by mid-year 2019
  • Higher risk-free rates in the United States will continue to challenge the emerging markets (EM) complex. However, spreads for the most vulnerable credits have already moved aggressively wider, now providing value. Our fixed income trading desk is tactically adding to EM credit to take advantage of what we expect to be a meaningful compression in spreads into the fall, and perhaps year-end

The Fed will no longer be stalled. The Federal Reserve set out on its “exit strategy” at the start of the decade.¹ A series of market concerns and economic worries delayed the trip. Even as asset prices rose and unemployment fell, inflation remained low and tepid wage growth failed to confirm labor market improvements. The tide has finally turned over the past year. The combination of firming inflation, broadening wage gains and a fiscal boost to growth means the Fed is now far less likely to temper its tightening plans. This represents not just a different Fed policy regime, but an increasingly more challenging environment for markets, too.

When risk assets no longer support the Fed’s mission, the Fed no longer supports risk assets. The emerging tension between the Fed and markets is noteworthy because it follows an extended period of a market-supportive Fed. In the wake of the financial crisis, the Fed added to its zero-rates policy by easing further with asset purchases (to boost spending and investment via higher asset prices and wealth creation). Our read in 2012 was that markets would recover well in advance of the economy, as we wrote: “U.S. data are now much less relevant for the stock market because the stock market itself is now a policy tool. By implication, stock prices will likely normalize faster than growth.”² With the S&P 500 acting as a “policy tool,” investors were compensated in advance of economic growth materializing. The Fed’s unconventional easing provided a goldilocks” environment for risk since it was win-win: Improving growth meant a self-sustaining recovery was taking hold; weak growth invited more Fed easing. This “goldilocks” dynamic was in fullest effect when the Fed was easing, but continued even as the Fed transitioned to rate hikes: The Fed scaled back rate hike plans in the face of economic and market concerns in both 2015 and 2016. That dynamic is now gone, in our view. The Fed is more firmly in tightening mode than at any point in the cycle.

The Fed seems likely to normalize, and go further. Investors were right to be skeptical of Fed hikes for many years when Fed policy turned out to be more dovish than communicated. That skepticism has outlived its usefulness though and turned out to be misguided a year ago, as we warned (“The rates pendulum keeps swinging”). Earlier this year, the introduction of stimulative fiscal policy further reinforced the Fed’s willingness to tighten policy (see “Fiscal easing invites more monetary tightening”) and that has been reflected in front-end rate expectations for the remainder of the year. The next big question up for debate is where the Fed will stop hiking rates in this cycle and how markets will digest it. If the “goldilocks” era meant markets could rally even if growth was stagnating, now, as the real economy gains traction, we believe markets are less likely to keep pace. Indeed, markets will be especially challenged if the Fed eventually hikes to above the so-called “neutral” level (where it is neither expansionary nor contractionary). Incoming economic information increases our confidence that the Fed will go down that path, as it has in the past.

The long-awaited cyclical lift means rates can keep rising, and don’t count on EM to stop it. Unemployment has fallen more sharply than most forecasters anticipated in the cycle, but lower unemployment did not coincide with accelerating wages or inflation. Now, with unemployment near 4%, we are starting to see the long-awaited cyclical lift in wages. The employment cost index is trending toward 3% for the first time in a decade and, crucially, those wage gains are broadening across regions. The first chart below shows how quickly wages accelerated earlier in the cycle in the Western region of the country, where the tech sector has been on fire. More recently, as the first chart below also shows, wage growth is finally broadening from the West to the rest. The income picture is even brighter when considering the recent benchmark revisions to GDP. Where previously the data evoked late-cycle concerns from a low savings rate, now the picture is one of more personal income and a higher savings rate (second chart below). The combination of higher wages and savings paints a picture of a healthier and more resilient consumer.

A line graph compares the employment cost index, as a year-over-year percentage, for the western United states and the rest of the country. Both lines have trended up since 2013. As of late June 2018, the western United States ranked at 3.5% and the rest

A line graph compares the revised U.S. savings rate and the previous U.S. savings rate as a percentage, 3m ma, between 2000 and 2018. The previous rate has trended below the revised rate in recent years. As of late June 2018, the revised rate ranked at 7%

To be clear, the pickup in wages and price pressures is still very different from the late-1960s, early 1970s dynamic of a tighter labor market and runaway inflation, which we see as a remote possibility in the context of today’s inflation-fighting Fed (first chart below). Relative to history, wages heading north of 3% in the coming year and inflation near 2% are modest, but in this cycle they are meaningful and should keep the Fed moving. The Fed will reach its estimated neutral rate (2.75—3%) with just two more rate hikes this year and two more next year. A sustained economic improvement should keep them on track toward our 3.5% estimate for the terminal rate (second chart below). This would mark a historical low for the Fed, but a historically wide gap versus other advanced economies. This is likely to keep the dollar from falling much, particularly versus EM, where higher front-end U.S. yields could extend the challenges seen this year.

A line graph shows U.S. core consumer inflation, as a year-over-year percentage, between 1958 and 2018. The rate ranged between 3% and 6% between 1958 and the early 1970s. The rate ranked at approximately 3% in late July 2018.

A line graph depicts the Fed funds rate between 2000 and projections out to 2021. The Private Bank’s economic outlook expects rates of 3% in 2019, 4% in 2020 and 4% in 2021; market pricing expects the rate to remain roughly flat at 3% over the course of t

On the topic of EM, don’t count on Turkey’s currency crisis to stop the Fed. Turkey’s economy is minimal in the context of global trade and GDP (1.12% and 1.04% respectively), as are the financial linkages vis-à-vis U.S. banks (first chart below). It presents a greater challenge for Europe and may delay the ECB further. The rates gap between the Fed and the ECB is already at historical extremes, and all we can say there is that records are meant to be broken. Broadening the discussion, we also do not see EM contagion, specifically relating to China, stopping the Fed. China caused a big scare for markets in 2015, as investors speculated on the unraveling of its balance of payments in the context of accelerating capital outflows. Fast forward to today, China’s capital account remains on lockdown, and domestic growth is better balanced and more reliant on consumption rather than overleveraged fixed investments. In addition, commodity imbalances globally no longer exist to the extent that they did just a few years ago (second chart below).

A bar graph shows domestic bank exposure to Turkey, as a percentage of GDP, for seven countries. Spain ranks at approximately 5%, France 1%, Italy .75%, the United Kingdom .5%, Germany .25%, Japan .10% and the United States .05%.

A line graph depicts the real commodity price index (1998 =100) between 1998 and late June 2018. The trend line falls from approximately 300 to 150 between 2014 and 2016— a period that is circled in red and labeled “fed spooked by commodity collapse.” The


Michael Vaknin
Chief Markets Economist, J.P. Morgan Private Bank

Joe Seydl
Capital Markets Economist, J.P. Morgan Private Bank

Jeff Greenberg
Capital Markets Economist, J.P. Morgan Private Bank

Vinny Amaru
Associate Markets Economist, J.P. Morgan Private Bank


BEA—Bureau of Economic Analysis
EU—European Union
FRB—Federal Reserve Board
GDP—Gross Domestic Product
P/E— Price-earnings ratio
SITC—Standard International Trade Classifications
USITC—U.S. International Trade Commission


² “When the S&P becomes a policy tool,” Macro & Markets September 2012.

³ During the previous cycle, the Fed’s estimate of the neutral rate was around 4—4.5% and the Fed eventually peaked at 5.25% in mid-2006.

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