NN IP: US tax cuts, the Fed and the strong euro

US tax cuts will probably only arrive in Q1
Over the past few months the White House and Congress have devoted a lot of time and political capital to their efforts to repeal and replace Obamacare. Last week the Senate voted against a “skinny bill” which would only have repealed some parts of Obamacare. As a result, the healthcare issue seems to be completely stranded for now, even though this has happened before. The key issue is strong disagreement within the Republican Party. Earlier on, a bill to simply repeal Obamacare was opposed by the GOP moderates. On the other hand, adding too many “sweeteners” to the bill will antagonize GOP conservatives. At the time of writing it is unclear whether the Republicans will try to reanimate the healthcare bill again. What is important to bear in mind is that the bill is part and parcel of the FY2017 budget resolution. The latter expires on 1 October, so that is the hard date which will definitely put a stop to the process if no agreement is reached beforehand.

For investors the most pressing issue is the prospect for tax reform/tax cuts. We have not changed our view there. First Congress will have to pass a FY2018 spending resolution as well as a debt ceiling bill before 1 October 1; otherwise there will be another government shutdown. Doing this is not easy because differences between the GOP moderates and conservatives also play a role here while Trump may want to get funding for his Mexican wall in the spending bill. Subsequently, the House and the Senate need to agree on a FY2018 budget resolution which provides a basic outline of budget priorities. This resolution needs to pass in the House and the Senate to enable the latter to pass tax reform with a simple majority vote. Needless to say, internal Republican struggles also present a hurdle here. The need to be able to show something before the 2018 midterms will act a big incentive to overcome these hurdles but tax cuts will not happen before Q1’18. The size of the tax cuts will crucially depend on what happens to the healthcare bill. The assumption now must be that the latter will not pass, which means that there will be no decline in the baseline tax revenue projection against which tax reform/cuts will be judged. As such the expected size of the tax cuts have decreased somewhat again because these tax cuts will have to be revenue neutral over a period of 10 years, at least on paper. Still this need not be a bad thing. The economy is near full employment and therefore not in obvious need of fiscal stimulus.

Fed sticks to the game plan
The key issues facing the Fed at this point are the combination of robust growth momentum and a tightening labour market, easing financial conditions and persistent downside surprises on the wage and price inflation front. With respect to the latter the FOMC’s working hypothesis is that temporary factors are holding core inflation down for now. Robust growth momentum and a declining output gap make the FOMC confident that the Phillips curve will kick in at some point, which is why they continue to forecast that inflation will converge to the target from below. On top of this, the easing of financial conditions since the autumn of 2016 despite three hikes during this period is tantamount to taking one’s foot off the accelerator to find that the car is gaining speed. All else equal, this suggests the driver should continue to take his foot off the accelerator, possibly at an accelerated pace. All this presents some pretty difficult trade-offs for the Fed. To make this a bit more tractable one could say that the Fed actually distinguishes two phases in the current tightening cycle: In the first phase the Fed wants to bring the nominal policy rate back to neutral because they deem that appropriate for an economy close to full employment with an inflation rate that is converging to the target. In the second phase they want to maintain this blissful equilibrium by shadowing the nominal neutral rate higher.

This is the sort of game plan that seems perfectly simple in theory but can be devilishly difficult in practice. The key issue here is that the neutral nominal rate is determined by r-star (the neutral real rate consistent with full employment) and the underlying expected inflation rate. R-star is pretty difficult to measure accurately in practice but the Fed uses the working assumption that it is currently in the lower part of the 0-50 bp range. If inflation expectations are anchored at 2% this means that nominal neutral should be a little above 2%, i.e. some four rate hikes away. This is the essential story behind the 4 dots between now and the end of 2018. Nevertheless, if inflation expectations have slipped than the nominal neutral rate may only be one or two rate hikes away, which seems to be the scenario the market is pricing. To make matters even more difficult, there are factors which could conceivably have a big short-term impact on r-star. A further strong increase in risk appetite could cause US financial conditions to ease a lot further, which would push up r-star. A big increase in the structural fiscal deficit would have pretty much the same effect. On the other hand, an increase in geo-political or US domestic political risks and/or protectionist measures could have the opposite effect.

The second phase is even trickier, even though the Fed will only embark on it if it is pretty certain that inflation expectations are anchored to the target. Until a year or two ago, the general view at the Fed was that r-star was held down by mostly cyclical factors such as private non-financial and financial sector deleveraging, the move towards tighter bank regulation, an increase in the degree of caution on the back of the traumatic 2008/09 experience, etc. However, now that the economy has reached full employment, r-star has barely risen, which at least points to the possibility that more structural factors are at play here. One reason could well be that r-star is not only a function of US domestic developments but also of global ones and the latter may well be more important in an integrated global financial system. The chief global drivers are the balance of global savings and investment appetite as well as global risk appetite. The failure of global growth to break the ceiling so far strongly suggest that these drivers are still within the range we have seen over the past seven years.

Despite all this, our base case remains that r-star will rise somewhat on the back of the more robust global growth momentum which carries better productivity growth performance with it. Still, the pace at which r-star will rise is very uncertain. The Fed dot plot suggests a rise of 75-100 bp in the space of 2.5 years. Historically, increases of this magnitude in the so-called Laubach-Williams estimate of r-star (which the Fed places a lot of weight on) have only happened twice. In the late 1960s President Johnson presided over a “guns and butter” policy, i.e. a substantial fiscal easing to finance an expansion of the welfare state and the Vietnam war, which quickly pushed up r-star. In the late 1990s, r-star jumped in response to the stock market and investment boom. It is hard but not completely inconceivable to imagine events that will trigger the same strong r-star response in the next three years. Besides all this, it is extremely unlikely that the Fed will end up fully shadowing r-star even if there were no uncertainty about its trajectory. All kinds of shocks may force the Fed to deviate from this. For instance overheating will require that the Fed raises the actual real policy rate above r-star but by how much will very much depend on the extent to which they are willing to allow for an inflation overshoot. The latter can be very valuable in cementing on target inflation expectations and creating an inflation buffer for the next recession.

The upshot of all this is that the path for the US policy rate is clouded in more uncertainty than during the typical post-war hiking cycle. An added complication is that the Fed will start balance sheet roll-off (or Quantitative Tightening) which will exert upward pressure on the term premium and, as a consequence, downward pressure on r-star. Because QT will be very gradual, the Fed expects the concomitant upward pressure on the term premium to slowly build over time. We agree but also feel there is no way of knowing this for certain. The risks reside on the side of Taper Tantrum-like jumps. At any rate the July FOMC statement confirms that QT is indeed coming to town as the Fed stated that balance sheet roll-off will start “relatively soon”. This does not make September a certainty, though, because it is somewhat weaker than “soon”, which is used to point to the next meeting. The reason the Fed wants to retain some flexibility is probably that there is a risk that investors could worry about the consequences of hitting the debt ceiling in September if the different factions within the GOP cannot come to an agreement. Apart from this the statement contained little new information. The most conspicuous element was core inflation was described as “running below 2%”, whereas previously this was “somewhat below 2%”. This is just an acknowledgement of reality, of course. What is more important is the Fed’s own inflation forecast, which expects inflation to remain somewhat “below 2% in the near term” but to “stabilize around” the target over the medium term. In other words, the Fed continues to believe the Phillips curve will kick in.

On the back of this statement there is no reason to change our Fed call for four rate hikes between now and the end of 2018 and the start of QT in September. However, we see maximum dovish risks to this call and these risks would realise themselves if short-term core inflation momentum and wage growth momentum fail to pick up in the next few months. In that case the rate path would adjust downwards toward only one or maybe two hikes over the next six quarters. However, QT will remain on auto-pilot unless growth falters significantly or the divisions within the Republican Party threaten to push the US Treasury market over the default cliff edge.

Some thoughts on euro strength
The recent rise in the euro, around 6% relative to the December-May average in trade-weighted terms, is a bit troubling. The ECB seems to be sort of in the same position as the Fed was in mid-2014, when the expectation of a future policy change in a hawkish direction pushed the exchange rate on an appreciation bandwagon. So far the ECB is only experiencing a watered-down version of this (back in 2014 the dollar appreciated 20% in the space of eight months) but the circumstances are the more or less the same. In mid-2014 the Fed was scheduled to end QE by October of that year and markets were speculating about the start and speed of the rate hiking cycle. The nature of ECB tapering is still shrouded in uncertainty but markets are also toying with the question when the first rate hike will come. These speculation received a bit more fuel this week because there is somewhat more evidence of a tentative uptrend in core inflation. The latter averaged 0.8%-0.9% between Q2’16 and Q1’17 but advanced 1.1% on average in Q2. A large chunk of this rise can be attributed to package holiday, airfares and accommodation services, but that still leaves the impression there are some underlying signs of life here. To be sure the path towards price stability is still a pretty long one. What’s more, if inflation expectations have fallen below the target, the ECB will actually have to overheat the economy. Finally, the recent euro appreciation, if maintained, is more than enough to wipe out the recent core inflation gain entirely for the next four to six quarters.

Of course, the exchange rate is by definition a two-sided issue. This observation is particularly relevant for the euro/dollar exchange rate, because over the past month or two the downside risks to the US money market curve have increased while Draghi’s Sintra speech has cause the market to bring the first ECB rate hike forward in time. If the euro appreciation continues on the back of a steepening of the ECB money market curve, the change in future monetary policy expectations will ultimately prove to be self-defeating in much the same way as the dollar appreciation forced the Fed to be lower for longer. As a result, the euro appreciation only reinforces our conviction in a “slow and stretch” taper, which may well be more dovish than the market expects. In particular, we see a non-negligible risk of continued purchases at a very low pace into 2019 to enhance the credibility of “lower for even longer” guidance. Whether or not this will be enough to stem euro appreciation is anybody’s guess. Exchange rates are ruled by extremely unstable expectations that are difficult to tame. Hence, ongoing downside inflation surprises in the US, or political brinkmanship around the debt ceiling, could well push the dollar lower against the euro and cause some sleepless nights for the ECB Governing Council.

Emerging markets: The escalating Venezuelan crisis
The big story in EM of the past week has been the escalation of the Venezuelan crisis due to the election of the controversial constitutional assembly. At least ten people died in protests last weekend. Probably less than 20% of the electorate went to vote, but the government claims that the turnout was more than 40%. The new assembly can and is likely to dissolve the opposition-controlled old parliament. So de facto, President Maduro is taking complete control of power. Pressure on democratic institutions has been gradually increasing during the Chávez and Maduro years, but it never got to the point where the elected parliament was completely being sidelined.

This autogolpe is unacceptable for the US, EU and most of the other Latin American countries. It cannot take long before meaningful economic sanctions will be announced. Meanwhile, Maduro has already said that the new assembly will order the removal of the critical chief prosecutor and the imprisonment of key opposition leaders. The latter was already effectuated Tuesday morning, when Leopoldo López and Antonio Ledezma were arrested by the secret police. Also, the President said that one of the first things the new assembly will decide is to strip the opposition legislators of their constitutional immunity.

If the US imposes sanctions on Venezuelan oil imports, the end game will start. Without the oil dollars, the Maduro regime cannot survive. The big problem, however, is that hundreds of thousands of civilians have been armed by the authorities in the past few years. So even if the army were to turn itself against Maduro, a civil war could erupt. What is encouraging is that in the past few months, key army leaders have dropped support for Maduro and resigned. Many of the key early-days comrades of Hugo Chávez have already left, which, in the eyes of many Venezuelans, has stripped Maduro of his legitimacy as Chávez’s heir.

All in all, it looks highly unlikely that the Maduro regime will survive long. The big question is how the regime will be removed, and at what cost.