By Economic Strategist, Hottinger Investment Management
Last week saw the release of the minutes from the Federal Reserve’s November FOMC meeting and public statements by Fed Chair Jay Powell on the future path of monetary policy. With most global financial markets except the United States experiencing a negative year to date, all eyes have been on the monetary policy of the US, the recent direction of which has been a significant cause of market instability in the last two months.
The spread between US Libor 3M and Euribor 3M, measures of three-month lending rates in the United States and Europe respectively, has approached 300 basis points (see chart). The last times US interest rates became this detached from European rates were before the Dot Com crash and the financial crisis; it’s a sign that the US economic cycle might be nearing a downturn. The US economic cycle tends to lead those of other countries and regions – especially Europe – and this means that US rates tend to rise earlier than they do in other places and you get these US/EU Libor spread peaks, as the chart shows.
The importance of the Federal Reserve and the US dollar not just for the US economy but for the global economy too underlies the phenomenon of this ‘US-first’ economic cycle. Europe, in particular, relies heavily on dollar funding to conduct both financial activity and real trade. Other central banks tend to follow the Federal Reserve if they wish to preserve the value of their currency against the dollar and maintain adequate dollar funding for their international activities. In emerging market countries with current account deficits and external finance requirements, higher US rates and dollar strength tend to push up the cost of borrowing independently of local central bank policy.
Further, the effects of higher rates on the US consumer typically suppress US import demand, which by its nature has a knock-on effect on other countries. In recent decades, the US has occupied the position of ‘consumer of last resort’ due to its high current account deficits, with consequences for aggregate demand in other countries. This position has changed in this decade as the rise of China and the value of their imports have made other regions, especially export-oriented Europe, less dependent on the United States.
It is therefore more likely the first factor (global dependence on the Fed) rather than the second (global dependence on the American consumer) that has had the greater negative contribution on international financial markets in recent months.
Will there be a Powell put?
With global markets and economies sensitive to US rates, there has been much speculation in recent weeks about whether there would be a so-called “Powell Put”, following the tradition of Fed Governors Alan Greenspan, Ben Bernanke and Janet Yellen who have often delayed policy changes or adapted their forward guidance on policy in response to events in US and global equity and bond markets. A “put” from the US central bank is essentially a commitment to prevent financial markets going below levels that could harm the real economy. In their most extreme and well documented guise, the ‘Fed put’ has resulted in a sharp cut in interest rates (as it did under the Greenspan put) or in the policy of Quantitative Easing (as it did under Bernanke).
Greenspan puts (1999 and 2001); Bernanke Put (2007)
Figure 1 shows the three occasions during which the Federal Reserve reduced interest rates in response to fading economic strength and deteriorating market: after the LTCM crisis in 1999, during the bear market in 2000 and 2001, and after the start of the financial crisis in 2007. The Federal Reserve also injected funds after the 1987 stock market crash and the Asian financial crisis in 1997. SPX Index is the S&P 500 and FDTR is the Federal Funds Target Rate, or the basic interest rate in the United States.
Figure 1: Federal Reserve puts. Source: Bloomberg
Bernanke QE Put (2008)
In the first iteration of the Bernanke Put, interest rates reached their ‘zero-lower bound’ which limited further monetary stimulus without introducing the controversial measure of negative nominal interest rates. In response, Bernanke initiated QE1, the first round of quantitative easing that consisted of buying US Treasuries and mortgage-backed securities. This started the long-bull run in equity markets that may only now be coming to an end. The next chart, Figure 2, shows how the S&P 500 index closely matched the volume of assets that the Federal Reserve owned in the years during which the policy of QE was in effect (2008-2013).
Figure 2: Bernanke’s QE put. Source: Bloomberg
Yellen Put (2013, 2015)
The market turbulence, known as the ‘taper tantrum’, in response to suggestions from the Federal Reserve in 2013 that it would withdraw QE led to the bank delaying that policy for 16 months. In 2015, concerns over growth in China and a bear market in emerging market equities caused the Federal Reserve to delay its first rate rise to December 2015 and to abandon three of the four rate hikes it planned in 2016.
Figure 3: Yellen’s put. Source: Bloomberg
In recent statements from the Federal Reserve and Jay Powell indeed, there was no specific indication of a Powell put; on this matter the minutes of the November FOMC meeting stated: “the turbulence in equity markets did not leave much imprint on near-term U.S. monetary policy expectations”.
However, markets have however interpreted last week’s policy guidance from the Federal Reserve as indicating that the bank is now not necessarily wedded to the three interest rate rises in 2019 that the September FOMC’s dot plot suggested; “monetary policy is not on a preset course,” the minutes state. This form of words gives the Federal Reserve the space in which to conduct what effectively amounts to a ‘put’ even if they don’t say it is one. With inflation breakevens indicating that markets think economic activity could be softening and with the slowdown in activity in China and Europe on their minds, this more dovish tone from the bank has settled some nerves.
However, markets may still be too sanguine; the Federal Reserve’s own models of inflationary pressures indicate that those pressures are still increasing (see Figure 4). Unemployment is below the level and wages are now growing at 3.5% per annum. The bank is mandated to respond to these first before taking into account the wider situation in the global economy.
Figure 4: The Federal Reserve’s economic models predict higher rates. Source: Federal Reserve Bank of New York; Bloomberg.
Is the US economic cycle less important this time?
As indicated above, the relationship between US and European interest rates and the reliance of global economic cycle on the US cycle may be less important today because of the rise of China. Both Germany (-0.2% Q3) and Italy (-0.1% Q3, revised) announced weak third quarter economic growth figures last week. There are individual explanations for the poor performance of each of Italy and China. Emissions regulations have held up German car production and exports, while political uncertainty in addition to low inflation and, concomitantly, high real interest rates in Italy could explain that country’s problem. However, with Q3 growth figures in Switzerland (-0.2%) and Sweden (-0.2%) also surprising on the downside, something else seems to be afoot. The common denominator could be China.
The Chinese have been trying to stimulate their economy by cutting reserve ratios for small and large banks after earlier efforts to tighten monetary conditions and de-lever banks’ balance sheets hit industrial companies and state-owned enterprises Nevertheless, Chinese factory growth continues to stall, with the index for manufacturing purchasing managers falling to 50.0 last week. The index for Chinese manufacturers’ import orders also shrank, from 47.6 to 47.1 (numbers below 50 indicate falling orders).
This matters for Europe because over the last few years the continent in general and manufacturing countries such as Germany, Switzerland and Italy in particular have solved their deficient demand problem with a combination of export growth – driven by growth in exports to China, and not to the US – and easy money from the ECB.
At the end of this year, that stimulus from the ECB will come to an end, with Governor Mario Draghi committing last week just to rolling over maturing bonds and not renewing stimulus on the grounds that the recent slowdown is due only to temporary factors and that Eurozone was merely returning to trend growth. Sabine Lautenschlaeger, a German member of the ECB’s executive board, said she sees nothing on the horizon that could alter the decision to phase out QE and was confident that the ECB would start raising short-term interest rates, currently set at minus 0.4%, next year.
However, if Eurozone growth continues to remain soft and headline inflation comes down further along with oil prices, any indication that the ECB will follow the Federal Reserve in 2019 in tightening policy could harm Europe at a time when external demand faces negative risks from rising interest rates in the US and contraction in China, and when compensatory fiscal policy action is heavily proscribed by the EU’s intergovernmental rules.
The global economy is at a delicate moment with uncertainty, slowdown or stagnation respectively in its three largest engines – the US, China and Europe. How things develop for economies over the next few months and into 2019 will depend largely on whether central banks overshoot on rate rises, and how things for markets will go will depend on whether monetary policy pivots towards a schedule that investors think the economy can handle.
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