I spent the past week in Knoxville, Tennessee, watching my daughter’s basketball team
play in a national tournament. I am the unofficial scorekeeper of the team, which makes
the experience even more interesting, as I track the games on a variety of metrics.
What I found is that the risks to my daughter’s team were different in each game,
depending on the abilities of the opposing team. It reminded me that various market
environments present different risks and, just as quickly as one game ends and a new
game against a different team begins, so too can environments change.
And that’s what we saw last week. One major risk that I have worried about for a year
now was the potential for the next European Central Bank (ECB) president to be a
monetary policy hawk. I felt that would create a significant headwind for European
markets, given that current ECB President Mario Draghi’s dovishness had driven down
systemic stress during his tenure. However, that risk dissipated last week with the
nomination of Christine Lagarde for the ECB presidency.
Lagarde was a long-shot candidate, with pundits expecting Jens Weidmann of the
German Bundesbank as the most likely choice. Weidmann, who historically had been a
vociferous critic of quantitative easing, softened his rhetoric in recent months in an
apparent attempt to secure the ECB position. However, in the horse trading that is a
part of determining who is nominated to EU leadership roles, French President
Emmanuel Macron was able to secure the nomination for his fellow French citizen,
Lagarde.
Like Federal Reserve (Fed) Chair Jay Powell, Lagarde is not an economist but does
have relevant experience given her current role as the leader of the International
Monetary Fund and in her past experience as the Minister of the Economy, Finance and
Industry. Based on all that I know of her and in particular from her statements in recent
years, I believe she is the most likely to continue Draghi’s dovish policies. I also believe
she has the potential to be a visionary as leader of the ECB. She has long recognized
both the disruptive and positive qualities of cryptocurrencies, blockchain and financial
technology in general. She is likely to work toward greater regulation that could
ultimately lead to greater adoption. What’s more, she is a career politician who may
ironically be better equipped to fend off growing attempts to politicize central banks.
All in all, I believe a key risk for European markets has dissipated.
As one risk recedes, another emerges
But just as one risk dissipated, another appeared. That happened on Friday with the
release of the US employment situation report. It showed that job creation in June was
very strong: 224,000 non-farm payrolls were added in the month, which was much
better than expected. This strong jobs report raised questions about whether the Fed
could justify cutting rates in July, which sent stocks lower. After all, the market had
assumed the Fed would be loosening monetary policy in the short term, which has been
an important catalyst for the recent rally in stocks. And so now a new risk — that the
Fed won’t be able to justify a rate cut in the coming months — has arisen.
However, I believe the Fed could certainly justify a rate cut. First of all, average hourly
earnings remain relatively tame at 3.1%1— well below where they would normally be at
this stage in an expansion, suggesting inflation is likely to remain well contained. And
while June’s jobs report was a blowout, it comes on the heels of more modest reports.
The three-month average job gain for the second quarter, factoring in downward
revisions to April and May, is slightly below the three-month average for the first
quarter and far below the three-month average for the fourth quarter.1 Alternatively,
the Fed could simply choose to raise its inflation target, as various Federal Open Market
Committee members have suggested in the last several months. While there is always
the risk that the Fed will not get as accommodative as the market hopes for, it will likely
err on the side of giving the market what it needs.
The good news is that we could get a greater understanding of the risks facing markets
this week through the words of Powell, who gives his semi-annual Humphrey-Hawkins
testimony to Congress. He will likely get questions on a few topics currently in the
news, including how he could justify a rate cut in the near term given relatively strong
economic data such as Friday’s jobs report — as well as the politicization of the Fed
given recent disparaging comments from President Donald Trump, and reports that the
White House had attempted to find a way to demote Powell. We were reminded just
today that the politicization of central banks could be a very real risk given Turkish
President Recep Tayyip Erdogan’s firing of his central bank governor.
We should learn more about what the Fed may do as we move closer to the July 30-31
Fed meeting. In the meantime, I believe that signs point to an accommodative Fed. The
ECB risk factor has gone away, but I don’t believe another has emerged in its place.
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