Fra BNP Paribas:
KEY MESSAGES
Wobbles in financial markets are likely to lead the
Fed to reconsider broader financial conditions.
A 10-15% drop in equities is usually the difference
between noise and signal, though previous
examples tell us it matters what the rest of the
economy and financial markets are doing.
Financial conditions remain “easy” and the
economy is on solid footing. We think the Fed will
continue its gradual pace of rate hikes, for now.
Equity scare: When should we be worried?
• US equities took another leg down on Tuesday as
concerns about the impact from the trade dispute
with China hit corporate forward guidance and
banks’ earnings disappointed. Uncertainty about
mid-term elections looms, while there was more
discussion in markets about the Fed hiking too
much.
• The risk-off move in markets sparked concerns
about the risks of an earlier economic slowdown
and fewer rate hikes.
• Equities remain up on the year, corporate spreads
are relatively compressed, fed funds is below
neutral, and there remains ample liquidity. The real
effective exchange rate, however, has moved just
above neutral. All told, broader financial conditions
remain accommodative.
Test cases: How has the Fed responded?
• A pause: The S&P500 declined by 12% over the
first two months of 2016 as fears of a China hard
landing mounted and the US growth outlook soured.
The Fed paused in March 2016 and changed their
forecast from four hikes in 2016 to just two.
• Didn’t blink: An XIV scare in late January of this
year drove the S&P500 down by just over 10%. This
time around, the FOMC’s gradual pace of rate hikes
went undeterred as the economic outlook remained
promising with the positive impact from
expansionary fiscal policy still in the pipeline.
What’s next? Watch overall financial conditions.
• In light of recent market moves, the Fed is likely to
reassess broader financial conditions. In our view, if
financial conditions move closer to neutral (ie, S&P
near 2500), the Fed could pause its rate hike plans.
• Facing a headwind from trade policy and in the
midst of a fading fiscal tailwind, we think the Fed will
likely be nimble in its approach to policy, accounting
for changes in economic and financial conditions.
