By Economic Strategist, Hottinger Investment Management
Last week, the People’s Bank of China announced that it would cut the reserve ratio requirement (RRR) by a further 100 basis points, the fifth cut since the start of 2018.
Higher reserve requirements for commerical banks not only directly constrain how much credit banks can create for a given level of deposits but also raise the cost for banks to lend if they do not have sufficient deposits. In order to lend, they first need to borrow from the central bank to meet the reserve requirements.
The PBoC hopes the reduction will stimulate over $100bn in extra lending. In the last twelve months, the central bank has taken a nimble approach to monetary policy. At the end of 2017, there was an expectation that the clamp-down on excess credit and leverage – particularly in smaller banks and within the shadow banking sector – would cross over into a broader policy of making finance more expensive by raising interest rates. As it became clear during 2018 that global supply chain activity was slowing and Chinese firms were reducing their inventories, however, the PBoC changed course and cut the RRR.
In recent weeks, new economic data shows that China’s privately-owned manufacturing sector shrank in December for the first time in almost two years. In November, industrial profits fell. The Chinese government, facing uncertainty over the outcome of tariff negotiations with the United States and slowing export and import volumes, is keen to do anything to prevent a so-called ‘hard landing’ of its economy, which could also have damaging political effects.
The RRR for smaller banks has fallen along with that for mainstream banks despite the risks that the former institutions pose for Chinese financial stability due to their weaker capital positions, opaque lending practices and dependence on interbank lending. This is because smaller banks have been a key provider of capital to private-sector small businesses and to less advanced but more politically autonomous regions in the west and north of the country.
Larger banks tend to prefer supporting state-owned enterprises on the implicit understanding that they are underwritten by the central government. However, smaller private firms provide the bulk of urban employment and are the backbone of China’s supply chains. It seems, therefore, that China’s central bank is prioritising the stability of the real economy over that of the financial system insofar as it can isolate the effects of each of these institutions on the other.
Last week, the Federal Reserve’s Chairman, Jay Powell, took the chance to clarify the Federal Reserve’s monetary policy for this year at the American Economic Association’s annual conference. Markets wanted Powell to follow the PBoC and say that the Fed will keep a close eye on the state of the economy and react accordingly. This is not surprising, since the loose monetary policy of the last six years has underpinned asset price inflation in the United States, as Figure 1 shows.
Figure 1: Taking an equal-weighted index of balance sheet expansion in the U.S., Eurozone and Japan shows deliver a close correlation with the S&P500 index.
On a fundamental basis, one might argue that the US economy merits higher interest rates. Unemployment could fall further, the labour force participation rate could rise further (as the most recent employment data attest) and wages are growing above 3%. While core inflation has dipped below 2.0% recently, it is not unreasonable to suggest that if the US sustains above-trend growth, stronger inflation will result and justify higher interest rates.
However, observing the performance of Europe in 2018 affirms the wise advice that past performance is no guarantee of future outcomes. The PMI data for December suggest that business activity in the US could decelerate signifcantly in Q1 2019 on the back of reports from manufacturers that consumer demand is slowing, tariff-related costs are rising and weaker activity in China has put downward pressure on inflation expectations. Markets therefore responded positively when Powell declared that he is open to pausing interest rate rises and changing the pace of balance sheet reduction.
Despite the decision last month to reduce the number of expected rate rises from three to two during 2019 to move closer to market expectations, investors have cut further the amount of tightening that they expect the Fed will do. Figure 2 shows the spread of what the market thinks a three month Treasury bill (T-Bill) will yield in 18 months’ time over the yield on the current 3M T-Bill. A negative spread implies that interest rates will start falling by the middle of next year.
Figure 2: A negative difference between the yield of a three-month Treasury bill starting in 18 months’ time and the yield of a three-month Treasury bill starting today suggests lower interest rates in 2020.
Last week, the spread turned negative for the first time since before the financial crisis, suggesting that markets think the Fed will start cutting rates in 2020. Much of this change happened after the last meeting of the Federal Open Markets Committee, which announced a more dovish strategy, indicating that investors think the economy could slow over the next year and that the Bank’s policy of two rate rises this year could be a cause of that slowdown. Further, lower expectations for future inflation due to both higher rates and other factors such as weaker demand mean higher real yields for a given nominal interest rate, meaning that less monetary tightening is required to normalise the economy.
Looking at futures markets, it would appear that markets would like the Federal Reserve to call off further rate rises altogether and take a leaf out of the PBoC’s book. Last week’s comments from Jay Powell suggest that he is listening. Markets will keep a close eye on what the Bank does next, and if investors are not satisfied, the recent market turbulence could continue.
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