This feels like one of those days where there has been an epoch shift or to be more specific the morning after the night before. It is not as if we have been caught by surprise, as unlike so many have been ahead of the curve about the world economic slow down, and hence the implications for interest-rates and monetary policy. But there will be much wider implications from this as we go forwards and let us start from the fact that the biggest economic decision of 2019 may have just been made by a technocrat.
What happened?
The US Federal Reserve is significant on several counts. There is the ordinary significance of it being responsible for monetary policy in the world’s largest economy and for its reserve currency. There has recently been an additional one as it has been the standard-bearer for voluntarily raising interest-rates. Yet last night we got a combination of this.
the Committee decided to maintain the target range for the federal funds rate at 2-1/4 to 2-1/2 percent……… In light of global economic and financial developments and muted inflation pressures, the Committee will be patient as it determines what future adjustments to the target range for the federal funds rate may be appropriate to support these outcomes.
No great surprise in the lack of a move last night but the promises that peaked at 3-4 interest-rate increases in 2019 have morphed into “will be patient” or perhaps 0. Then there was an additional statement which copied a part of what has become the European Central Bank model.
The Committee is prepared to adjust any of the details for completing balance sheet normalization in light of economic and financial developments. Moreover, the Committee would be prepared to use its full range of tools, including altering the size and composition of its balance sheet, if future economic conditions were to warrant a more accommodative monetary policy than can be achieved solely by reducing the federal funds rate.
So what has been called Quantitative Tightening or QT where some of the bonds bought previously are allowed to run off has run out of steam or “economic and financial developments”. The use of the word financial is significant as frankly it only reinforces the view that past falls in equity markets have driven this and we do get a flicker of democratic involvement ( I will leave readers to decide if that is good or bad) as of course they upset President Trump.
Next comes something which regular readers will know is something I have long suspected which is that in any slow down QE4 will come down the slipway. Or to be more specific the Federal Reserve balance sheet will no longer be contracting but will be expanded again. A particular significance of this will be that it could start with the balance sheet already being over US $4 Trillion in size.
There are various consequences of all of this. Two of them are major themes of my work with one of them being the earliest. As central banks went “all in” in terms of monetary policy I feared they would delay any exit policy and thus end up in the wrong cycle. The Fed deserves some credit for at least trying ( unlike so many others) but if not too little it was too late. Next is the issue of “junkie culture” where I feared we would be unable to wean ourselves off cheap credit and yields well that looks like where we are at right now. Some of you deserve credit for pointing out that the “new normal” would mean interest-rates would not go above 3% as that is looking rather en vogue today. That is in spite of the annualised economic growth rate being reported as 3.4% and the unemployment rate being reported as 3.9%.
Along this road the concept of independence of the US Federal Reserve and Chair Jerome Powell has folded like a deck chair, although some ( often ex-central bankers) retain a touching faith in the concept.
The Consequences
Equity Markets
The issue here is summarised to some extent by this tweet from James Mackintosh of the Wall Street Journal.
The FTSE 100 dividend yield ended 2018 3.5 percentage points above the 10-year Gilt yield, the most ever. One possibility: Market pricing risk of dividends being slashed after Brexit. Another: UK stocks are cheap. Or Gilt yields far too low.
After last nights Powell U-Turn whilst Gilt yields are in my opinion too low the reality is that going forwards they look more likely to stay there than before. Therefore on that measure the equity market looks cheap. Or to express it in another form the Yellen put for equity markets which replaced the Bernanke put has not been replaced by the Powell put option. This does not mean that they cannot fall but it does mean that monetary policy will do its best to stop them falling.
This brings us to the concept of the Plunge Protection Team a phrase I do use and sometimes I am joking. But this monetary policy U-Turn following the way that Treasury Secretary Mnuchin spoke to the largest banks just before Christmas looks like a concerted effort.
Fiscal Policy
That to my mind has just seen a shift too and it comes from bond yields. Pressure for them to rise has just ended at least from one source. If you take the view that bond yields are the sum of expected future interest-rates then the latter has been shifting lower. If we stay with the US forecasts of 4% bond yields now face a reality of a ten-year Treasury Note yield of 2.67% and a thirty-year yield of 3.02%.
Thus fiscal policy just got cheaper and in some places it is currently very cheap if we look at a 1.24% ten-year Gilt yield in my country the UK and ultra-cheap if we look at Germany with its ten-year Bund yield of 0.18%. Let me offer you some thoughts on this.
- I know people like to laugh at the Donald but his fiscal plan of tax cuts has coincided with an economic slow down and now has got less expensive via lower bond yields.
- The concept of us all turning at least partly Japanese gets another tick in the box as they have never fully escaped the easing cycle either.
- Was the original plan of central bank “independence” to allow policies the politicians could never get away with?
- Ironically the countries that can most afford a fiscal boost such as Germany are those most set against it. Of course an element of its lower yields is due to its fiscal surplus but to my mind only a small bit.
- Politicians seem to be more in favour of fiscal policy when it is more expensive (higher bond yields) rather than cheaper. I cannot fully explain that but it often happens, perhaps they are just slow on the uptake.
Comment
There is a lot to consider here and the truth is some of this we have been observing over the last month or two as markets have adjusted to a newer reality. I have developed a new theory in the credit crunch era which is that conventional thought once it believes something takes quite some time to change after the evidence has shifted or the complete opposite of the famous quote attributed to JM Keynes.
When the facts change, I change my mind. What do you do sir?
In reality many have continued on with thoughts about interest-rate rises in 2019 perhaps most bizarrely in the case of the ECB. Whereas for now central bankers seem to have Taylor Swift on repeat to sooth away any such thoughts.
We are never ever ever getting back together,
We are never ever ever getting back together,
You go talk to your friends, talk to my friends, talk to me
But we are never ever ever ever getting back together