The art of dangling the ‘easing’ carrot
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Investors are a tough audience at the best of times and that was certainly on display on Wednesday after the US Federal Reserve delivered its first interest rate cut in a decade and threw in an early suspension of its balance sheet reduction efforts.
Rather than dangle the carrot of a lengthy easing cycle, Jay Powell described the 25 basis point reduction in the fed funds rate as a “mid-cycle adjustment” and said the current resilience of the US economy did not herald an extended period of monetary easing.
The Fed chairman’s response cut against this year’s dramatic decline in Treasury bond yields, triggering weakness in equities and perhaps more importantly a firmer US dollar and higher short-term Treasury yields.
One can forgive financial markets for a sense of disappointment as the Federal Open Market Committee statement focused on “the implications of global developments for the economic outlook as well as muted inflation pressures”. This has been the driver of falling Treasury and other sovereign bond yields in 2019 and why the FOMC began the year with its policy U-turn after raising overnight borrowing costs in December.
But the expected 25bp reduction and early termination of shrinking the balance sheet is not the end story for investors.
Yes, the US economy looks resilient at the moment, with one data release on Wednesday showing private payrolls rose 156,000 in July, beating estimates, and raising the question as to why there is a need for easier monetary policy. Indeed, Esther George and Eric Rosengren — the presidents of the Kansas City and Boston Feds respectively — voted against Wednesday’s 25bp cut, saying they preferred to keep rates steady as they were worried about financial stability.
Running counter to the duo’s view is a FOMC that is observing a slowing global economy, little sign of US-China trade tension alleviating, ebbing inflation expectations, the Brexit temperature climbing, and a rising tide of negative-yielding debt around the world.
Charles Seville, co-head of Americas Sovereigns at Fitch Ratings, says:
“In cutting rates by a quarter-point . . . and signalling an earlier end to balance sheet reduction, the Fed is acknowledging downside risks to growth from outside the US, which are being reflected in weaker investment and net trade, and prompting other central banks to shift to an easing stance.”
While weaker global growth and other downside risks were highlighted by Mr Powell during his press conference, he downplayed threats to the US economy and the need for additional easing.
The problem with taking such a broad view is that the last thing a FOMC (already enduring the full force of President Donald Trump’s pressure) needs is to see tightening financial conditions. That means keeping a lid on the US dollar and Treasury bond yields. As it stands, a broad measure of the reserve currency currently sits in elevated territory when taking a long view.
The prospect of further US dollar strength remains likely. The health of other regions is more precarious. Before we heard from the FOMC and Mr Powell on Wednesday, trade talks in Shanghai ended abruptly and China’s official manufacturing purchasing managers’ index recorded its third straight monthly contraction at 49.7. Meanwhile, the eurozone economy expanded just 0.2 per cent between the first and second quarter as annual inflation to July eased to a 17-month low of 1.1 per cent.
Not a lot of sunshine there and that’s what worries investors. The euro fell below $1.11 for the first time in two years as Mr Powell spoke, while the dollar index jumped 0.6 per cent to its highest level since May 2017.
A firmer dollar has already hurt S&P 500 companies. At the halfway point of the current quarterly reporting season, the majority (3/4) of S&P 500 groups have beaten lowered estimates and the good news is that the prospect of an “earnings recession” looks unlikely. But as FactSet note, S&P 500 companies that generate more than half of their sales outside the US are reporting double-digit earnings declines for the second quarter.
Equities look vulnerable to further earnings downgrades as margins feel the pain from a stronger dollar, alongside higher wages and simmering trade tension. For all of Mr Powell’s reluctance to signal an extended easing cycle, equities are trading on that hope as double-digit earnings expectations for 2020 look ambitious, particularly should the dollar extend its gains.
Toby Nangle at Columbia Threadneedle highlights the risk for equities that have benefited greatly from the pronounced drop in bond yields this year:
“Absent earnings growth, equity prices have been rising because earnings multiples have been expanding, and multiples look to have been expanding largely because bond yields have been falling, given the weaker economic environment. It remains to be seen whether multiples could remain at historically high levels if the four rate cuts that are baked into US Treasury bond valuations failed to transpire.”
Quick Hits — What’s on the markets radar
Debt-friendly triple Bs — There are now 23 companies from the lowest rung of the US investment-grade universe that have undertaken measures to boost the quality of their balance sheets over the past 21 months. Analysts at Bank of America Merrill Lynch estimate this covers $483bn of bonds, representing 12 per cent of the US investment-grade index and a fifth of the triple B-rated sector, excluding financials and utilities. BofAML makes the following points:
“That represents a sizeable and growing segment of the IG market, which is highly unusually focused on deleveraging well before a recession. Instead of all the fears of BBBs getting downgraded to HY [high yield], we are seeing the opposite — improving credit quality and undoubtedly many large capital structures ultimately ending up instead getting upgraded.”
The reward for investors is fairly significant as BofAML say these select companies have outperformed the broad market “by 15-20%” in risk premium terms “during the first year after the debt-friendly action”.
Bank of England sitting tight — A sliding pound that reflects the risk of a hard Brexit does not make for a happy central bank. All the BoE can do is watch and wait for events to unfold, a view that is shared by the market as interest rate futures price in a rate cut by year-end as a better-than-even chance.
Expect little change in tone at Thursday’s BoE meeting. TD notes:
“In our base case the MPC retains the gradual & limited rate hike language, but we see a 1/3 chance that it’s dropped due to the deteriorating global backdrop.”
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