In a contemplative moment US Federal Reserve chair Jerome Powell might have recently thought about the old saying that “no good deed goes unpunished”.
In July the Fed performed a good deed, lowering interest rates by 25 basis points. Despite being committed to a rate-hiking stance, the Fed took cognisance of “further downside risks”, even though the US economy is experiencing steady growth, record-low unemployment and subdued inflation.
But instead of being lauded by looking forward, and by not rigidly adhering to an established stance, the Fed was harshly punished. The Dow dropped sharply to negative territory in August, losing 3.05% in daily trade on 14 August, while bond yields fell to their lowest levels since President Donald Trump’s election victory in 2016.
Lower interest rates usually support equity markets. So, what happened this time?
The Fed simply did not come across as believable after the 25 basis-point cut, which coincided with a host of other global risk factors, most importantly the trade spat with China. Markets expected at least 50 basis points as Powell described the cut to be a “mid-cycle adjustment”. More cuts are not guaranteed, Powell said.
Yes, recent US economic data has not been that bad, with retail spending and job creation remaining strong. And wage inflation has ticked up 3% on an annual basis (finally), justifying a cautious cut by the Fed. But investment is slowing, leaving markets less than reassured, with GDP growth already under pressure as the effect of Trump’s tax cuts fizzles out and his belligerent trade posture casts a spell over the global economy.
Since the rate cut, things have become even worse. China has adopted a hard-line approach, with Trump now seemingly realising that higher tariffs causes domestic prices to raise, and hardship for US consumers, as well as lower stock markets. And not income for the government.
Then the US bond yield inverted further as yields of the ten-year fell below that of the tw0-year, usually a precursor of a recession, and following in the footsteps of the three-month a few months ago. Euro bond yields have dropped to new lows with German Bunds falling further into negative territory as the German economy faces possible recession.
Not all of this can be attributed to the Fed. But there is a real possibility that the Fed might be behind the curve in this cycle amid falling global growth and increased trade tensions, affecting all major trading nations now.
The danger is that further cuts by the Fed might be ineffectual going forward. The Fed is still officially in a rate-hiking mode. But already the forward market is pricing in at least two further cuts this year. The market punishment is therefore a real test for the Fed’s credibility.
This is against a backdrop where the Chinese are fighting back, something that Trump apparently did not reckon with. The depreciation of the renminbi to above seven against the dollar presents major new challenges to the US and global economy. A weaker Chinese currency will boost Chinese exports, and generally leads to lesser global price pressures. At a time that global central banks, including the Fed, are attempting to counter deflationary pressures.
There is a real possibility that the US might experience a recession in mid-2020, a presidential election year, with the Chinese apparently ready to sit it out in the trade war, offering no concessions after Trump extended the implementation date for his new tariff onslaught from September 1 to mid-December. Already the Chinese have lessened their exposure to US treasuries, with reserves of $3tr ready to be used in the event of an escalating trade war.
Whatever the Fed does, the July hike will almost certainly prove not to have been a “mid-cycle adjustment”. Most likely it was the start of a rate-lowering cycle. Markets are clamouring for more good deeds, a greater commitment to the loose monetary policies of the past. What Powell and his team are learning, is that once markets, or people, become used to the effect of good deeds, it is very difficult to unwind them to more onerous realities – higher rates being one of them.
The tried and tested cut-and-stimulate strategies by central banks have saved global economies in the past. But more and more evidence points to this strategy not being as effective as in the past – with the EU and Japan the best examples. With rates at or around 0% for an extended period of time, inflation and growth remain low.
Equity markets have performed well over the past two years. But this could be the last spurt of the past expansive decade. Falling bond yields certainly tell the story of investors having no faith in the central bank strategies of the past, at least as far as it affects the economy. That is why a strange anomaly is gaining traction. Investors are now increasingly paying central banks to hold their money in bonds, instead of central banks paying interest to them on their issuances.
In this brave new world, there is increasing scope for more good deeds. If not, the Fed will be punished.
Maarten Mittner is a freelance financial journalist and a markets expert.