For months, Goldman’s optimistic take on the economy drew raised eyebrows across both the sell and buyside, and nowhere more so than the bank’s forecast for 4 Fed rate hikes in 2019, a number that is even higher than the Fed’s own dot plot forecast which anticipates 3 rate hikes next year, not to mention the market’s own implied prediction of less than 1 rate hike in the coming year.
Well, on Sunday night Goldman capitulated and in a note titled “The Ides of March” published late on Sunday by Jan Hatzius, the banks capitulated on its optimistic, and hawkish, projections, and now calls for less than a 50% probability of a rate hike in the March.
How does Hatzius justify this long-overdue capitulation? It’s hardly the recent economic data, which while conceding that it has slowed down, Goldman notes that it has transitioned from “exceptionally strong to merely strong.”
Relative to the turmoil in the financial markets, the economic numbers have been remarkably stable recently. Admittedly, jobless claims have risen and November payrolls fell somewhat short of expectations. But a report showing 155k new jobs and a decline in the (unrounded) unemployment rate to a new 48-year low of 3.67% is hardly weak in an absolute sense. Combined with the rebound in the November ISMs and firm consumer confidence readings, Friday’s report kept our current activity indicator (CAI) at 2.8% in November. This is down from a pace of 3.6% over the summer but still roughly 1 percentage point above the economy’s potential growth rate. In other words, our CAI implies that growth has transitioned from exceptionally strong to merely strong
Hatzius also observes a similar softening in inflation data, even if not one in wage growth; even so, “the wage and price inflation misses have been relatively minor, and we expect an increase in nominal wage growth to the 3¼-3½% range as well as a pickup in core PCE inflation to 2.2% by the end of 2019.”
However, while Hatizus refuses to admit a slowdown in either jobs or inflation, he notes that a “much more significant change is the sharp tightening in financial conditions.” As Hatzius adds, “for a variety of reasons—including an initial bout of concern about Chairman Powell’s “long way from neutral” remark, the inevitable slowing of GDP and profit growth from their exceptionally strong pace, and the broadening tension between the US and China—rising investor anxiety has pushed up our FCI by about 80bp since early October. If the FCI remains constant at its current level, we estimate that tighter financial conditions would take ¾-1pp off real GDP growth over the next year.”
It is this tightening in financial conditions that Goldman finally admits “may lead to fewer rate hikes than seemed likely earlier” for one simple reason: “if the financial markets have already delivered greater restraint, the committee just doesn’t have as much work to do in pushing up the funds rate.”
Fed officials tend to downplay this link in their public communication because they dislike the “Fed put” narrative, i.e. the simplistic idea that they let the stock market dictate monetary policy. Nevertheless, we think they do—and should—respond to the economic implications of material and sustained changes in financial conditions by adjusting the funds rate path.
In other words, while the Fed downplays the “Fed put” narrative – according to Goldman – that’s all that really matters in the end. Thanks for clarifying… even though we are confident that JPM’s Marko Kolanovic will promptly brand this latest admission from Goldman as, drumroll, even more “fake and bad news.”
So what are the practical implications for Goldman’s funds rate call?
As Hatzius explains, despite the FCI tightening, recent Fed communications suggest that a hike in December is still very likely (in our view 90%). However, according to the Goldman chief economist, “the probability of a move in March has now fallen to slightly below 50%.”
A decision to pause in March would also be consistent with the likelihood that tariff-related uncertainty will look particularly high around the end of the 90-day grace period on March 1.
Yet even while admitting it was wrong, Goldman refuses to go all the way, and Hatzius hedges by saying that “this is a close call because there are still good arguments for a March hike, including a continued positive fiscal impulse that should keep growth above trend in Q1 even with tighter financial conditions, as well as a funds rate that remains at the very bottom end of the committee’s range of neutral rate estimates even after a December hike.”
Additionally, Hatzius admits that there will be one easy way to test if Goldman is right in just two weeks: the bank’s forecast of no hike assumes that the median number of 2019 hikes in the December dot plot moves down from 3 to 2; So if the median instead stays at 3 hikes, “the probability of March would increase again” according to Goldman.
Finally, despite Goldman’s capitulation on a March rate hike call, the bank still sneers at the market’s current pricing for the funds rate, which discounts less than one full hike in all of 2019. Why? Because in Goldman’s forecast, the economy continues to grow above trend for most of the year, the unemployment rate falls further below the Fed’s estimate of its longer-term level, wage and price inflation gradually move higher, and we see a return to quarterly hikes in June that last through the end of 2019.
And here, out of nowhere, Goldman mentions rate cuts: just in case it is proven absolutely dead wrong and the Fed decides to start easing next year:
By contrast, the likelihood of sizable rate cuts—which would probably coincide with a recession or at least a serious recession scare—remains quite low over the next year or two, in our view. Current growth momentum is good, the FCI tightening is material but far from devastating, and the two key historical recession drivers—financial imbalances and a serious overheating problem—are still not visible. We therefore think that the storm will pass and this will keep Fed officials on a normalization path, albeit a more tortuous one than up to now
So what if any impact did Goldman’s rate call change have on the market? A quite profound one, because while equity futures were sliding and 10Y yields lower on the session, pushing the dollar index to session highs early in the overnight session, moments after Goldman’s note hit, the Bloomberg dollar index tumbled to session lows…
… while the Euro spiked, largely as a result of the sharp repricing of Fed vs ECB rate hike odds in 2019, because one look at Euribor vs Eurodllar 2019 calendar spreads, shows that suddenly the odds of a rate hike by the ECB are higher than those in the US! In other words, after a violent repricing in the past month – largely thanks to Powell’s recent comments and continued disappointing economic data out of the US – the market now sees the ECB as more hawkish than the Fed in 2019.