Summertime state of play for the central banks
Whether or not the upcoming rate cuts in the US and the EU turn out to be “insurance cuts” or the beginning of an easing cycle into a recession is critically important to ideal macro-driven investment positioning. To the extent the central bankers can engineer another dovish course correction which prolongs the global economic expansion in real terms, which is by far the dominant narrative currently reflected in risky asset prices, it will be a job well done. The challenge, though, is that simply easing policy at the end of an expansion doesn’t reliably prevent recessions. Otherwise, with skillful central bankers in charge, countries could ostensibly avoid recessions forever. Optimism is running high this time around though, at least in the US, because there are no flagrant examples of systemically-important excess leverage, and there is a distinct lack of late-cycle inflationary pressure, both of which tend to precede recessions. There should be, of course, inflationary costs of excessively loose policy, but those are lingering deep in the background, almost irrelevant for now. More problematic at the current juncture are the twin challenges of diminishing marginal economic benefit of loose policy, and the successively lower starting points for policy rates as economies experience slowing performance. Of course, this is especially true in Europe and Japan where policy rates are already negative.
When viewed in isolation and in light of very recent data, the case for rate cuts in the US may seem somewhat flimsy. Yes, inflation is below target, but it’s stable, and the data on the US consumer remains robust. The labor market is strong, wages are growing, and consumer balance sheets are healthy. However, it’s probably not appropriate to view the US in isolation from the rest of the world, nor is it appropriate to view the US economic health solely in light of very recent economic data. Late last year, evidence surfaced in the housing market and cyclical underperformance of broader US economic data that the Fed had overtightened, i.e. gotten above the neutral rate of interest. Remember the confusion and conflicting official views of where in fact the neutral rate of interest was? See: Off Message. Subsequently, once it was clear enough that the monetary policy environment was likely suppressing economic growth, Chair Powell’s pivot toward dovish accommodation at the turn of the year kicked off a remarkable loosening of financial conditions. Though policy rates have remained unchanged, the (mostly) consistent and intensifying commitment to dovish policy this year has been enough to reduce long term rates by a further 70 bps, tighten Investment Grade credit spreads by 50 bps, boost stock prices by 20-odd percent, cut the VIX in half, and keep the dollar basically range-bound. Frequent readers know my obsession with the relevance of FCIs (Financial Conditions Indices) and hence the major relaxation of capital costs year-to-date should be positively affecting the recent economic data. So, in short, while it feels like the US is doing well-enough and doesn’t need a rate cut, the anticipation of multiple rate cuts in which investors have been marinating for seven months means the Fed needs to deliver a 25 bps cut to merely maintain the easy financial conditions they have apparently worked hard to achieve.
Thematically, it’s almost as if they have been grasping at reasons to cut rates.1
Now, by a circular argument, I can also make the case that because financial conditions are so loose, cutting by 50 bps this month is unnecessary and ill-advised. The interest rate market has only a modest possibility of 50 bps implied in the pricing for the July meeting (24.5% according to Bloomberg WIRP as of mid-afternoon on 7/16), so the rates market isn’t really “demanding” a 50 bps cut. The real probability of 50 bps is actually less because the choices are not simply 25 or 50. The Fed may actually cut the IOER and RRP rates by 30 bps to again re-center the effective Fed Funds rate within their target range. And that’ll be a real 30 bps cut, not 25. This is my base case, because it seems like a nice way give some satisfaction to the various dovish perspectives on the committee.
In addition, the US economic performance shouldn’t be viewed in isolation from global growth data as it relates to ideal Fed policy. That global data remains weak, and it may or may not turn up, and ultimately the distinction will determine (in my view) whether the Fed cut is just insurance, or the beginning of a protracted cutting cycle. Somewhat annoyingly, there are at least two international linkages which are contributing to the need for the Fed to deliver a rate cut despite “OK” US data – first, if global growth remains weak and further easing is economically justified from the other G7 central banks, the dollar will likely strengthen. Secondly, large cap US companies have significant non-US revenue dependency, so while they are American companies, many are sensitive to non-US growth slowdowns. Historically, as global growth and global trade volumes slow, S&P earnings growth also suffers and hence, so do stock prices and credit metrics. So despite healthy domestic data, financial conditions can tighten again through both the currency and risk asset channels, thereby necessitating a response from the Fed which they can choose to do preemptively.
So which is it going to be, insurance cuts or cutting cycle? It’s too soon to tell for sure, but factors unrelated to the healthy US consumer and labor market are likely to be the determinant. If the US dispute with China ends (I define this as tariffs are rolled back to 2017 levels), then a late cycle global growth rebound would be likely. Unfortunately my view remains that the current tariff levels remain in place for enough time to affect the growth and trade volumes directly and indirectly through supply chain rerouting and slower fixed investment. This still isn’t enough at this point for me to call for a continuation downward in global growth. A lot of good has been done by loose financial conditions, which will continue to help offset the status quo trade impacts. It’s close though, and even marginal hawkish decisions on the trade front would be enough to tip the balance.
1Thanks to Brandon Merrill for the help on this rationale.