Macro 5 Pager – Macroeconomic Momentum – 8 July 2019

> The world economy’s slightly chaotic showings reflect the likely end to a world balance dominated by the US, as well as the hunt for a new world order. This multi-faceted balance would include the US, China and Europe.
> This quest for a new equilibrium can be witnessed first and foremost in the current less coordinated and cooperative context, where each country seeks to get the most out of a situation where the rules are changing. Border tariffs are just one example of this.
> In the short term, this leads to uncertainty that drags down economic activity, as well as investment. Growth is slightly more sluggish across the board, while inflation remains contained and is still a far cry from the central bank’s target, especially in the euro area.

> There is a tendency towards continued accommodative monetary policy. Going too fast when all the risks for the economy have not fully emerged means taking the risk of having an insufficient impact and running out of options when the situation becomes more tricky.
> This would be the case for the US, where interest rate cuts being made too quickly would mean a fresh surge in liquidity, promoting more real estate lending and corporate credit from non-banking institutions, so excesses already seen would become even more severe. This would also heighten risks on these markets and curb the Fed’s ability to act in the event of a future crisis.
> Another key point is that long-term rates are set to remain very low for a very long time, until such times as this new world balance emerges: this will force the financial sector to reinvent itself.

The document is available here Macro 5 Pager – Macroeconomic Momentum – 8 July 2019

Solid US job report in June

The #US June #employment report shows that the drop seen in May (72 000) was temporary. The June figure was 224 000 and 191 000 for the private sector. The average for both measure is close to figures observed in 2016 and 2017. No necessity for the Fed to act rapidly. In 2017, the Fed was tightening smoothly.

On the wage side, the deceleration is rapid at 3.14% on a year (3.4% in Feb.). Graph shows that the Fed rate can manage a plateau as long as wages do not drop rapidly. This would be caused by a strong growth slowdown. It’s not the case yet. Therefore, nothing is expected on the Fed’s side in July.

The US yield curve is completely inverted.

That’s it, for the last 2 days the rate over the 30 years US has gone below the fed funds rate. All interest rates of the US curve are now below the fed funds rate.
This reflects a terrible concern for the future. Investors no longer want to take bets on the future.
It should be noted that the inversion of the curve no longer reflects a compression effect resulting from the rise in the Fed rate as expected last autumn, but an effect of poor expectations for the future. The two schemes are very different and the second is the most worrying.

Such a signal has always been a precursor of two points:
the first is a decline in Fed rates. For macroeconomic reasons (the data are still robust) and for the credibility and independence of the US central bank, I hope that this rate cut will not take place in July (or even here)
The second point is that this configuration of US interest rates is always a signal of future recession. Simply put, it is not only investors who have poor expectations about the future. The rapid fall in interest rates is simply a signal for the perception of the future. This one is not specific to financiers. The US recession will certainly take place in 2020.
We can imagine that until then, the tenant of the White House will be firing on all cylinders to show that he has done everything possible to avoid this decline in activity during an election year. The pressure on the Fed is going in this direction, as is the pressure on China. But if he fails, there will be no shortage of scapegoats. Jay Powell, the Fed President, will be in the front row but also probably Xi Jinping, the Chinese President who will not have put all the goodwill necessary to reach an agreement with the US. “Heads I win, tails you lose”

Can we expect lower Fed’s rate in July ?

The possibility of a 50 basis point interest rate cut by the US Federal Reserve is on everyone’s lips. The dots chart published at the end of the June 19 meeting indicated that rates would remain at the current level in 2019, but it showed that 7 members suggested a 50 bp decrease in 2019 (stability is calculated on the median of the results).
That was all it took for observers to switch to a similarly sharp decline at the July 30-31 meeting. The explanations given are those of Donald Trump’s pressure on the central bank either through threats relayed on Twitter or by the members appointed by Trump to the FOMC.

Such an interpretation raises several questions
The first is that at the Fed, the president always has the last word. Jerome Powell’s recent comments do not give this sense of urgency about lowering rates. This implies that the July rate cut, if it were to take place, would be more than a palace revolution since its president would be outvoted.

The second point is that the macroeconomic data also do not reflect the urgency of a change in the central bank’s strategy.
To gauge the economic situation I used the CFNAI index calculated by the Chicago Fed. It includes 85 indicators of the federal economy (from industrial production to retail sales, employment and orders for durable goods). The calculated indicator is centered on 0, and a value below -0.7 (on the index on average over 3 months as shown in the graph) suggests a risk of recession.

Since 1985 (the beginning of the great moderation), I have then measured the changes in the pace of the Fed’s monetary policy. The first graph shows the fed fund rate and the points used to mark the shift towards an accommodative monetary policy.

The second graph shows the dates of monetary policy changes and the CFNAI index.
Since 1985, monetary policy changes have taken place when the CFNAI index is close to -0.7, i.e. when the risk of recession becomes clearer. The only exception is 2007 when the issue of liquidity on many financial structures was raised. This is a special case.
The current level of the index is not consistent with a decline in Fed rates unless we imagine a deep break in all US indicators for June and July. This is not our scenario.

This means that, in the absence of economic or financial justification, a reduction in the Fed’s rates and a defeat of its President would first reflect a collapse in the credibility of the US central bank due to its loss of independence. As the world’s most powerful financial institution, it is likely to cause significant turmoil in financial markets. Should we take this kind of risk? I don’t think so.

The Fed’s message in 8 points

The Federal Reserve message is clear:

1- Macro data remain robust and expected inflation is low

2-Risks on the economic prospects are on the upside

3 – The Fed will adjust its rate if necessary but nothing is on the agenda

4 – The dots’ graph doesn’t give information as it shows one drop in 2020 and one hike in 2021

5 – Powell introductory statement indicates a bias on the downside for the Fed’s rate in the future.

6 – Long term rates dropped on this perception even if nothing has been said on the agenda. The 10y is now below 2% and the 30y below the fed funds rate for the first time in this cycle

7 – In the past, when all rates are below the Fed’s rate it’s a signal of recession. The drop in the Fed’s rate will come but will not be sufficient to avoid a recession.

8 – The reason is that low long term interest rates reflect low expectations on the future. They can’t reverse spontaneously. Economic phenomena are persistent

The Fed is in no hurry to adjust its monetary policy

In its monetary policy statement, the Fed says there is no reason to lower interest rates rapidly. Activity data are still robust and inflation remains moderate. Therefore, as long as there is no sudden inflection, there is no reason for the central bank to rush to adjust its monetary policy. (This is what I mentioned here)

The dots’ graph, reflecting the FOMC members’ expectations, considers that the fed funds rate will be stable in 2019, decline once in 2020 before going back up again. in 2021 at the current level.

The US central bank, which does not want to hurry given the economic situation still strong, does not want to give signals on what it will do. This is the end of the Fed’s forward guidance. It does not commit to anything, thus confirming its desire not to tie hands with commitments that may not be in line with changing circumstances.

ECB: How to burn ammunition for nothing

In Sintra, at the ECB seminar, Mario Draghi stressed the risk on growth and the difficulties of converging to the inflation target (close but below 2%).

If additional risks materialize then the ECB could reduce its rates and restart an asset purchase procedure. The idea is to take back and accentuate what has been the success of the ECB since 2013. (Low rate = less incentive to defer its wealth over time given the low return associated with has been strong support for a stronger momentum for the domestic demand)

At the same time, Draghi called for an active economic policy. On this point, the failure to implement a euro area budget reflects non-homogeneous behavior in the euro zone. As a consequence there will be no common fiscal policy in the euro area. One can not therefore imagine a two-component euro-zone policy.

A major rule of the theory of economic policy is that it requires as many instruments as objectives. There are two objectives (growth and inflation) and one instrument, monetary policy.

This will not work especially with a series of negative external shocks. In 2016/2017, monetary policy benefited from a favorable international context even if fiscal policy was not active. Today, the environment is no longer as buoyant and the absence of fiscal policy will make it difficult to cushion external shocks. The ECB will act alone and becoming more accommodating it will burn ammunition for a poor result.