This article was written by Richard Horswill. All views and opinions expressed are strictly his own.
The global economy has been spluttering for the best part of two years now. The highly anticipated lift off and an expectation of strong growth after the pandemic has continually swung between risk on or risk off as the data dependant administrators and lapdog markets have been buoyed and then let down continually. The major contributors to global demand and supply, the US, Europe, China, Japan and the wider developed regions have been generally trending down, with no evidence of any sustained increases in the growth dynamic. The only outlier, the United States, has been seemingly the only dominant economy bucking the trend! Or at least so we have been told by the mainstream sources. Fiscal remedies, which have been very market friendly to say the least, have now come under scrutiny with the recent comments by the Federal reserve chairman at the Jackson Hole Symposium suggesting the voting members of the Fed have succumbed to revisions in that narrative which has led to interest rate cut speculation, indicating that the strong and resilient US economy may be softening at pace. This has been particularly evident after the job revision data from the Bureau of Labour statistics miscounted the last twelve months data, overestimating job gains by 818,000. The consequences of the largest economy in the world falling into recession is one of significant proportions particularly as no other economy is in a position to drive global demand as China did after the 2008 great financial crisis. So how can one square the circle to achieve the promised holy grail of soft landing and thus global recovery that our esteemed leaders have been continually touting in this globally synchronised world post Covid?
The prominent indicator that I have discussed in previous articles relates to the potential ‘bull’ steepening in the US treasury market. This indicator is playing out as anticipated, in line with the slow but ongoing dis-inflation and this is regardless of the tight oil market, created by primarily OPEC 2 supply cuts which have emboldened the sticky inflation. The two year treasury yield has fallen sharply, whilst the longer dated rates have fallen at a slower rate. This has led to un-inversion in the 5/10’s rates, with the more important 2/10’s rates now only a few basis points from un-inversion. What is this telling us though? Markets are starting to price in significant rate cuts from the Federal Reserve which is why the two year rate is coming under pressure as market participants can see weakness in the mainstream narrative and are keen to take advantage of the current rates. The inversion which has been prevalent for not far off two years has continually indicated future low growth and inflation (money supply) expectations, and now the Central banks of the world may be realising that they have over played their hands. Funny how the long and variable lags in monetary policy are very evident when rates rise, but expectations when rate cuts are on the table initially lead markets to over estimate their effects particularly in ‘heavily weighted’ stock market indices. Come the September decision, a rate cut may see some temporary market euphoria; however, one must ask how can a rate cut really be seen as positive? Surely, cutting interest rates in this manner is more of an attempt to provide stimulus to a flagging economy. The lags however will mean that the cuts will have little to no immediate effect and will, I believe, ultimately lead to a sharp series of cuts culminating in a return to the low interest rate environment that we left prior to the twin supply shocks of Covid and energy. These moves will be driven instrumentally by market forces with Central bankers being forced to react to the trend.
The banking side of the equation is also somewhat interesting. Interest rate cuts are typically viewed as an opportunity to borrow by the market, however banks do not necessarily feel the same way. As rates fall, the banking industry will typically tighten its lending standards reflecting concerns over spending in the economy by business, which will in turn reflect on retail spending, and the significant possibility of labour market weakness, potential job losses and the spiral into further economic weakness. Banks see the immediacy of economic troubles when delinquency rates increase and in these circumstances lead ultimately towards debt default. If banks further reduce lending in the debt based system, this will trigger further downside risks. It will also encourage the banks to seek refuge in government bonds, opting for safe and liquid assets, placing further stress on Central bankers to cut rates. A vicious circle! Also, with savings rates at very low levels, the consumer will more likely be inclined to pull back on spending and maybe look to save, particularly if the employment picture looks a little murky. These mechanics will almost certainly lead to further dis-inflation meaning the 2% target and beyond could be well within reach in short order. The banking system and its reaction function to the economy will significantly influence how the central bankers will decide on rate policy, not the other way round.
To conclude, the unintended consequences of inverting the yield curve over such a long period, undermining the banking mechanism, and taking for granted the the time lines in regard long and variable lags, leads me to be reminded of an old adage. ‘Markets tend to move up on escalators but come down in elevators.’ I think this could be very much an appropriate analogy for the interest rate picture over the coming months. And another good one, “This time is different.” It rarely is, if ever; however I’ll leave you, the reader, to ponder this!
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