INSIGHTS

On September 13, 2019

Global Monetary Policy: Easing like Sunday Morning

In anticipation of the Federal Reserve lowering rates next week at their meeting and the announcement this week that the European Central Bank (ECB) reduced rates to -0.50% and increased their purchasing of bonds a month, we believe it to be worthwhile to look at where we may be headed in policy and market action. Now we may be accused of being a bit presumptive about a future event such as an interest rate cut next week, however, we feel a bit confident in that the market is currently pricing in a 99.9% chance of a rate cut according to the Fed Fund Futures. That is about as far as we would be looking, though we may nod to another cut by year end for amusement’s sake. The Futures market is pricing in a January 2021 Fed Funds rate of 1.25% which would be denoting a recession based on past cuts, and we don’t see that at this time.

The shift in interest rates and overall easing has been very pronounced over the last year. Bloomberg’s map of 22 major global central banks’ intentions and median forecasts from October 2, 2018 (left) to July 16, 2019 (right) show just how dynamic the shift has been.

The anxiety that this has spawned in the markets is palpable yet has had little impact on equity market returns. So far, year to date, the Dow Industrials total return is 18.89%, S&P 500 22.01% and the Russell 2000 is up 17.61%. In terms of fixed income, we have seen the Bloomberg Treasury Index up 5.81%, U.S. Aggregate Index up 7.79% and the U.S. Corporate total return up 12.27%.

Arbor Research did an interesting analysis on the news trend featuring easing and tightening, and the bias is heavily toward easing. We would argue this has more to do with the negative bias that has increased interest in the reasons why the central banks may be easing (negative conditions for economic growth or market liquidity) and not that the easing would be accommodating to the economy.

So now that we have an onset to accommodating mode, one should question the effectiveness. In looking at the last 30 years of the G10 (Group of 10) interest rate policy and inflation, we begin to see a diminishing effectiveness of just using the monetary levers.

Though rates have been in a downward trend, the last decade following the Great Recession has created a new abnormal. Consumers, Corporations and Governments have become accustomed to historically low interest rates and any shift higher has created a governor in the system. For those who feel 30 years may not be enough, we would offer a crude secular analysis of 5,000 years of interst rates from Bank of America Merrill Lynch and the Bank of England.

Two quick points: The period of 1825 to 1920 had short-term rates above long-term rates the vast majority of the time. Recall not much regulation in the banking system could lead to inflated margins for lending institutions without fear of reprisal. The last quadrant shows we are precariously close to the lowest long-term rates on record (we made note of this in our piece last week discussing the value of the S&P 500 dividen yield surpssing long term rates and the historical record of its success: https://www.aamlive.com/blog/201908/contrarian-market-signals-what-is-certain-about-uncertainty).

Somewhat messier though is the reaction of the central banks’ intention relative to the volatile shift in inflation.

With regards to unemployment as a mandate of the central bank, the developed market unemployment rate currently stands at 4.68%, the lowest level in nearly 20 years and well below the average of 6.54% during that time frame.

As an example, the Federal Reserve has lowered rates and made a shift in its intention that initially began in December 2018 when certain market liquidity became strained and lending standards began to tighten. This all occurred as the “matriarch of uncertainty” – trade war – began her march forward. For those who may be curious, the “patriarch of uncertainty” is the investor themselves and the idiosyncratic behaviors that each participant battles no matter what level of investor they are and what time of the market cycle they find themselves in.

So, with lower bound regions with which to cut to “stimulate” the economy, the effectiveness of these cuts is appearing more and more about optics than actual substance. They have had little benefit to the overall economies of Europe and Japan, yet we tend to find safety in numbers and are always looking to be in a race to “Averagarianism.” This is an ode to the tremendous book “The End of Average” written by Todd Rose, an amazing read that applies to the many hardwired traits that lead to a mitigation of excellence (our interpretation). To corroborate this point, the Federal Reserve of San Francisco did an analysis that was released in February 2019, “How Much Could Negative Rates Have Helped the Recovery?” and concluded that “Allowing the federal funds rate to drop below zero may have reduced the depth of the recession and enabled the economy to return more quickly to its full potential. It also may have allowed inflation to rise faster toward the Fed’s 2% target. In other words, negative interest rates may be a useful tool to promote the Fed’s dual mandate.”

One would assume that this has not proven effective for Japan or Europe and would suggest they ask them for their thought. Funny, you mention that as reported in July, the Fed did just that by attempting to study the Bank of Japan’s “yield curve manipulation” as a potential viable tool for themselves. We are not sure replicating the growth of Japan since these tools came into effect is an appropriate course of action. For further detailed analysis on this, one should refer to the tremendous piece written by Scott Colyer on the Japanification of the Global Economy.

Ultimately, even with the bounds of monetary policy shifting beyond the limitations of yesteryear, fiscal policy is what is required, in our opinion. While this may provide agreement in broad principle, with such a divisive political environment both here and abroad, this is easier said than done. A simple infrastructure package becomes dead in the water for fear of one party over the other getting credit for the growth or the blame for increasing the overall high deficits that are being run up. We would not confuse the current shift in monetary easing as an end all be all as the markets and economy can shift. Ultimately, we believe that we are in the later stages of the cycle, but not the end. The central bank’s playlist can shift from the Commodores “Easy” to the “Eagle and the Hawk” from John Denver.

CRN: 2019-0913-7686 R

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