Markets are questioning central bank relevance
Pushing rates even lower unlikely to stimulate economy
EUROPEAN Central Bank governing council member Olli Rehn told the Wall Street Journal on Thursday that policy makers should come up with an “impactful and significant” stimulus package at their next monetary policy meeting in September.
Normally such a pronouncement would spark animal spirits, sending riskier assets flying higher and causing government bonds to crater on the prospect for faster growth and inflation.
But instead, European equities fell, dragging the MSCI All-Country World Index to its lowest level since the start of June. Government bond yields in the eurozone and elsewhere continued their march lower. Taken together, the moves are a clear signal that the global economy may be too far along the path toward a recession for central banks to prevent it.
Put another way, the central bank “put” may be a thing of the past. At this point, investors perceive central banks as doing little more than pushing on a string by lowering rates that are already near or at record lows.
If negative interest rates — essentially paying borrowers to take out loans — haven’t stimulated the economy by now, pushing them further into negative territory isn’t likely to make any difference.
Investors no longer need to imagine the day when a major central bank official goes all in on the need for extreme monetary stimulus, including even possibly buying equities, and markets yawn. That day came and went.
After all, nobody is saying that credit is too expensive or unobtainable. Consider junk-rated Ghana, which announced plans on Thursday to sell 20-year bonds. Or WeWork, whose junk-rated bonds hit a record high this week of 102.5 US cents on the dollar even though the company said in a regulatory filing that “we cannot predict whether we will achieve profitability for the foreseeable future.”
One could argue that the global economy would be much worse off if not for such low interest rates. One could also argue that cheap money has stopped being a net benefit to the global economy and that central banks may have reached the point where they have lost relevancy.
Pressure builds on the Fed
The Federal Reserve has reversed course and started lowering rates, and bets are rising in the bond market that it will not only keep reducing rates but do so in bigger chunks.
The odds that the central bank lowers its target for the federal funds rate by half a percentage point at the next monetary policy meeting in the third week of September jumped to about 50% on Thursday from zero at the start of this month.
This comes despite Commerce Department data showing retail sales among a control group – which are used to calculate gross domestic product and exclude food services, auto dealers, building-material stores and gas stations – rose an annualized 9.7% in the three months through July.
That’s close to the 10.2% surge in the same period through May that marked the strongest pace since September 2003, according to Bloomberg News.
So if consumers are so confident, why are bond traders so pessimistic? It’s because they know consumers are fickle and that things like unemployment and spending are lagging indicators and can reverse quickly. In fact, unemployment was at its lowest point in the cycle just before each of the last six recessions. It may be happening already. The Bloomberg Consumer Comfort Index of sentiment just tumbled for a second week in its biggest back-to-back slide since March 2011.
Risk aversion flourishes
Casual observers might look at the 6% slide in the S&P 500 Index since its peak on July 26 and conclude that it’s nothing more than a healthy correction and nothing that should incite panic.
After all, the S&P 500 is still up 13% for the year and the decline is relatively small compared with the almost 20% plunge between late September and Christmas Eve of last year.
True, but that hardly gives a full picture of market sentiment. A custom Bloomberg index that combines 18 indicators tracking equities, bonds, currencies, commodities, volatility and liquidity calibrated back to the financial crisis to measure whether markets are in a “risk-on” or “risk-off ” mode fell on Thursday to its lowest level since mid-2016.
At negative 2.88, the gauge has crumbled from last year’s high of about 40 at the start of October. It doesn’t take a rocket scientist to understand why investors are so risk averse. Not only has the synchronised global recovery turned into a synchronised slowdown, but risks beyond the economy are emanating from nearly every part of the world.
Some of those include increased tensions with Iran; North Korea test-firing missiles again; the UK careening toward a hard Brexit; political turmoil in Italy and Argentina; unrest in Venezuela; and the end of a landmark arms-control pact between the US and Russia, to name just a few headwinds.
“Virtually every day for the past month we’ve been adding more risk-off assets into our portfolios,” Mark Holman, the head of TwentyFour Asset Management, told Bloomberg News.
Japanese role reversal
Here’s something else investors probably never thought they’d see in their lifetimes: Japan has turned into a high yielder in the bond market.
Although still low in an absolute sense, Japan’s five-year notes yield about 0.60 percentage point more than similar maturity government debt from Germany, which is a record, according to Bloomberg News’s Charlotte Ryan.
And even though yields in both Japan and Germany are below zero, investors can use derivatives to hedge and turn those negative Japanese yields into positive ones through cross currency basis swaps.
There are two things to consider here. The first is that it’s actually hard for investors to find any Japanese bonds.
The Bank of Japan has bought so many of them through its quantitative easing program that there are some days when none are traded.
The second is that the last thing Japan needs right now is an influx of foreign capital that would push the yen up even further. A Bloomberg index that measures the currency against a basket of major peers has risen to its highest since 2012.
A stronger currency could further restrain Japan’s export-reliant economy. The International Monetary Fund said last month that it expects Japan’s gross domestic product to expand only 0.4% in 2020, the slowest pace of any major economy it tracks.
Brazil currency war twist
In 2010, when major central banks began debasing their currencies by slashing interest rates to near zero – or even below – and printing money to buy financial assets, Brazilian Finance Minister Guido Mantega famously labelled the moves nothing less than a “currency war.”
Well, it’s happening again, with major central banks rushing to ease policies under the auspices of shoring up their economies but knowing such moves will also put much needed downward pressure on their currencies. And Brazil is even getting in on the action – but with a twist. Its central bank plans to sell dollars from its foreign reserves for the first time in a decade in a move that will keep its currency from weakening too much.
The real surged the most in more than four months, gaining 1.61%.
What Brazil seems to be worried about is that too much weakness in its currency might spur a capital flight. And though dipping into reserves can often rattle markets, especially in a nation with history of currency crises, this time investors aren’t concerned, according to Bloomberg News’s Aline Oyamada.
That’s because Brazil has been consistently buying dollars, pushing reserves up 90% over the past decade to a near-record US$386bil.
Policy makers said late Wednesday that in addition to selling dollars in the spot market, the central bank will also offer reverse currency swaps – the equivalent of buying dollars in the futures market. The last time the central bank sold dollars on the spot market was at the beginning of 2009, in the aftermath of the global financial crisis.
Tea leaves
Freddie Mac says the average rate on a 30-year US mortgage has dropped from 4.94% in November to 3.60% now. But there’s not a lot of evidence that the drop in borrowing costs is doing anything to entice people to buy new homes.
An index from the Mortgage Association of America tracking applications for a loan to buy a home is no higher now than it was in December.
So when the Commerce Department on Friday reports its data on housing starts for July, it may be worth it to skip the headline number and go right to what’s happening with permits, which are a better indication of current demand because starts generally reflect deals that have been in the works for months. Permits for June fell 5.2% to a rate of 1.232 million units, the lowest since May 2017.
The median estimate of economists surveyed by Bloomberg is for a small, 3.1% rebound in August to a 1.270 million rate, which would still be lower than anything seen since last August, with the exception of June’s numbers of course.
“Insensitivity of demand to lower financing costs suggests there are significant structural forces at play, such as worker shortages and a shift in preferences away from ownership to renting.” — Bloomberg Economics. The views expressed here are solely that of the writer.