Those readers that have spoken with us over the recent past will know that our outlook is for the Fed to pause and that we feel there is an equal chance of a rate hike or indeed a cut as the next move in the Fed funds rate. We think the Fed will utilise their balance sheet rather than the fund's rate to add/withdraw liquidity during a period of high data dependency.
Finally, on 8th February Moody’s upgraded its Russian sovereign rating to investment grade. The move takes the LT foreign currency rating to Baa3 (stable outlook) from Ba1 (positive outlook) and moves the rating in line with S&P who upgraded the rating in February last year to BBB- and Fitch who has maintained an investment grade rating (currently BBB-) throughout the 2014 sanctions and lower oil price period. Moody’s stated the main driver for the upgrade ‘is Moody's conclusion that the sovereign's vulnerability to such shocks has indeed materially diminished and no longer constrains the rating to sub-investment grade.
In my early days as a fund manager markets were only concerned with one data point; the trade balance. That was a very long time ago, and these days markets focus intently on payrolls and the unemployment rate which on the face of it suggest continuing strength in the US economy. However, it’s worth noting that the US unemployment rate hit a cyclical low of 4.4% in May 2007 and yet the US entered recession in December, just seven months later. That example alone should highlight that payroll watching is not really as insightful as some would have you believe.
Part II from a piece by our macro-economist Bob Gay:Should Financial Markets Celebrate Powell’s Pivot?
Two other developments might have given hawkish FOMC participants reasons to pause and reflect. For one thing, market measures of inflation expectations had declined significantly since the December meeting. This explanation, however, is not very persuasive because the Fed tends to rely on survey data on inflation expectations, which tends to be more stable than market measures that probably have been influenced by short-term developments such as the drop in oil prices.
This is part I of a commentary titled ‘Should Financial Markets Celebrate Powell’s Pivot?’ from our macroeconomist Bob Gay
At his press conference following the FOMC meeting of January 29-30, Fed Chairman Powell expressed the Board’s decision to be ‘patient’ in implementing future adjustments to its policy rate. The media immediately dubbed his statement as a ‘pivot’ away from the forced march toward policy normalisation over the past two years that steadily had raised the funds rate and had begun to shrink the Fed’s bloated balance sheet.
Yesterday both the ECB and the Bank of England slashed their growth forecast for this year, blaming a plethora of ongoing concerns, from trade frictions and a slowdown in China to political instability and the ‘fog of Brexit’. The ECB now believes that the EU economy will grow by just 1.3% the year, down from the 1.9% it forecast only 3 months ago, whilst the BoE believes the UK will fair slightly worse at 1.2% growth, down from the 1.7% predicted in November.
A commentary from the UN Conference on Trade and Development (UNCTAD) on ‘The Trade wars: The Pain and the Gain’ discusses a new UNCTAD study, analysing the impact of US-China tariffs and the threatened tariff increase scheduled for March. In December the US delayed a threatened tariff increase to 25% on $200bn of Chinese goods until March 1 to allow time for negotiations to take place. Ms Coke-Hamilton from UNCTAD noted ‘Our analysis shows that while bilateral tariffs are not very effective in protecting domestic firms, they are very valid instruments to limit trade from the targeted country’.
The leader of the free world delivered his State of the Union address to Congress yesterday in which he touched upon a range of foreign and domestic issues without providing many details on policy. The 82-minute speech called for bipartisanship, on his terms of course. Here are some of the highlights.
Federal Investigations – ‘An economic miracle is taking place in the United States and the only thing that can stop it are foolish wars, politics or ridiculous partisan investigations’.
For a long time we have had a major concern for the banks in Italy and therefore have no exposure to banks in general, fearful of the contagion that could happen at any time given the swings in market sentiment regarding Italian debt and politics. This we feel is a huge risk to the European Union.
Yesterday there was an interesting report that looked into Italian debt; with public borrowing reported to be 1.5trln euros concentrated on the balance sheets of Italian banks and a further EUR425bn in other major European banks.
Over the weekend Ignazio Visco, the Bank of Italy’s Governor warned of the downside risks to the central bank’s forecast for economic growth after the nation slipped into a recession in the last quarter of 2018. The recession, Italy’s third in a decade comes as the bank’s latest growth projection of 0.6% GDP growth for 2019 and 1% for 2020 start to look optimistic,
The largest pension fund on the planet, Japan's Government Pension Investment Fund, reported earlier that it lost more than 9%, over USD138bn, in the last quarter of 2018. The drop in value was the biggest since April 2008. In 2014 the fund changed its strategy to add more stocks at the expense of domestic bonds, approximately 50% of the fund’s assets are now invested in foreign and domestic stocks. In the same period, the S&P 500 fell 14%, the biggest fall since September 2011 and the Topix fell 18%, the largest quarterly decline since 2008.
As expected, the Fed left interest rates unchanged at its January meeting and the accompanying statement was viewed as having a dovish tilt as it pointed to a pause in the tightening cycle and prompted market debate whether the US rate-hike cycle has peaked. Jerome Powell also adopted a dovish tone in the press conference acknowledging ‘the case for raising rates has weakened somewhat’ and inflation risks ‘appear to have diminished’
Yesterday evening, in what many expect to be a pyrrhic victory, Theresa May achieved her Hail Mary pass by holding off the Cooper and Grieve amendments. It came at a cost. First, she whipped her party against her own Withdrawal Agreement towards the Brady amendment which demands she now renegotiate an “alternative arrangement” to the backstop. Second, she promised to bring whatever (un)altered deal the EU are willing to offer back to the house for a vote on the 14th of February.
Another day, another flag over global growth expectations. Yesterday, as China reported a decline in industrial profits, Caterpillar posted its largest earnings shortfall in a decade citing “lower demand” from China. Being a natural barometer of industrial and construction industry confidence, markets retracted, particularly across industrials, technology and energy stocks, with Caterpillar itself down over -9% yesterday. The Dow Jones Industrial Average and S&P 500 both closed the day down -0.8%. The China slowdown theme continued with Nvidia blaming its cut in sales expectations on deteriorating demand “particularly in China”.
According to reports, the World Trade Organisation (WTO) is about to begin an investigation into the US$250bn of Chinese goods that Donald Trump has slapped tariffs on over the last few months. The WTO will launch the inquiry into the US tariffs on Chinese goods, suspecting that the duties are not in line with requirements that all WTO members give each other the same tariff treatment.
The request for an inquiry on tariffs comes from China and is the second time of asking. The first was last month and was vetoed by the US.
Banks do tighten lending standards for other reasons, of course. Borrowers become too big a risk for a host of reasons ranging from debt burdens being too great to cash flows being too little. I expect to see a rise in loan defaults and delinquencies in the years ahead. Yet, neither of those warning signs have reared their ugly heads. So, banks have had little reason to cut back on corporate or household lending, and in fact have been relaxing lending standards on balance over the past year. That virtuous circle is destined to end, especially with signs of a global slowdown spreading. In that context, it is worth contemplating the root causes of what is weighing down global growth – namely, an unprecedented overhang in income and wealth inequality that has created a savings glut, imposition of tariffs and other conflicts that hinder global trade and pose barriers to capital mobility, and the dearth of value-adding investment opportunities in a world besot with excess capacity and political gamesmanship.
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Away from Bob's final piece, we took note of a Handelsblatt newspaper report saying the German government has slashed expectations for gross domestic product growth for this year to just 1%, as opposed to the 1.8% that it was expected just 4 months ago. There were several reasons for the downgrade, from a slowing global economy to Brexit. The report did state that the government expects growth in 2020 to pick up to 1.6%. In 2018 the German economy grew by just 1.5%, the slowest in 5 years. The outlook of 1% is in line with the IMF’s view of 1.3% (down from its earlier forecast of 1.9%) and the Ifo institute view of 1.1% GDP growth.
The report comes on the back of recent German economic figures that have been disappointing. The ZEW, which is a monthly survey of approximately 300 analysts and economists showing the balance of optimism on the German economy, came in earlier this week at just 27.6, far below the market's expectations of 43. We also noted that the PMI and IFO data also missed by a margin.
Consider then the implications of short-term rates remaining at or below 3% for an extended period. In the usual recession scenario, the Fed raises its policy rate to the point where bank lending is either unprofitable or unwise. When that happens, banks invariably tighten lending standards, some of the less worthy borrowers struggle to obtain funding, and activity is constrained. To be clear, this ‘cleansing’ of debtors is a prerequisite for the next expansion; procrastination or life support, both of which waste valuable financial resources, simply delay the day of reckoning and make recessions longer and deeper.
Now consider then the implications of short-term rates remaining at or below 3% for an extended period, which is the Fed’s current outlook. Namely, the Fed expects short-term rate instruments, like commercial paper and overnight loans that are the main sources of funding for banks, to remain well below the current prime lending offered to commercial banks’ best customer – now 5-1/2%. Because the Federal Reserve has moved so gradually and predictably in raising short-term rates from very low levels, banks have been able to raise lending rates slowly as well, thereby maintaining ample margins on loans. In fact, loan margins have been at historic highs ever since the Fed lowered its policy rate to zero in the wake of the Global Financial Crisis. Banks tend to follow the Fed in adjusting lending rates to the cost of short-funding, albeit with some delay (i.e. banks mark up prices over costs), except at very low interest rates. This pricing behaviour implies that the Fed uses its policy rate in part as a tool for restoring banks’ balance sheets during times of stress as well as the converse - a means to cool off lending that threatens to overheat the economy.
That cyclical margin on loans is why an inverted yield curve is not necessarily a good predictor of recessions at very low interest rates. The Fed would have to raise the cost of borrowing above 5% to make loans unprofitable, and hence warrant tighter lending standards, whereas FOMC members now project the neutral policy rate at less than 3%. In short, an inversion of the yield curve enough to curtail lending does not seem likely anytime soon. Moreover, the Fed’s gradualism and predictability in recent years also has translated into a very gradual and manageable increase in borrowing costs. Indeed, the notion that Fed policy somehow has been destabilising or damaging to the real economy because interest rates have risen from very low levels is pure foolishness. Normalisation of the Fed’s balance sheet, on the other hand, has become problematic because it is on a collision course with the horrendous US budget deficit.
Western central banks face extraordinary challenges in unwinding their 10-year experiment with unconventional monetary policy that has left them with trillions of dollars of financial assets on their balance sheets and real policy rates still near zero. The Fed, as the first mover, will bear the brunt of these challenges for many reasons.
Contrary to neoclassical theory in which economies supposedly settle into stable equilibriums, economic expansions always engender imbalances in either the real economy or the financial sector. Their origins often are rooted in the destabilising tendencies of business investment and the undisciplined and profligate nature of most governments.
This morning China announced its fourth-quarter GDP growth, coming in at 6.4%, matching market expectations, whilst adding the official economic growth for 2018 came in at 6.6%, the slowest pace of growth since 1990 (still a figure that the rest of the world would give their right arm for!). Although the headline figure may have been a little disappointing, there were bright spots included in the data release. These included retail sales, which rose 8.2%…