The past month or so, US equities have been zealously barreling towards past highs, buoyed by the most exceptional and exquisite of all financial drugs: forward guidance.
Mostly, however, the markets’ high originated far abroad in Europe; Portugal, to be precise. Mario Draghi’s dovish tone convinced investors of the ECB’s ability to use both the rates and quantitative easing mechanism to bolster growth. Given in the past decade or so that global developed-market rates tend to move synchronously with each other, the march upward of US equities wasn’t exactly surprising either.
Nothing in this saga after Draghi’s recent speech has come as all too unexpected, including Jerome Powell’s warnings on the global economic outlook. The proverbial sea of central bank governors is teeming with doves, eager to cut interest rates as soon as the slightest threat of a slowdown or (God forbid!) a recession rears its ugly head. It seems to make sense; who wants the music to stop?
Until you realise what the current US federal funds rate is.
One question springs up instantly from this: where’s the wiggle room? If things do go topsy turvy and then some, what can Powell do? You could say he could use quantitative easing. When you’re one of the biggest global players, though, and your best maneuver is a policy that’s efficacy is doubtful at best, you might indeed find yourself asking how you put yourself in that position.
Is it really worth exhausting your best shot on somewhat reduced growth from a large boom in the economic cycle? Yes, there are the fears of a trade war with China. Yes, concerns regarding Iran persist. And yes, we have no idea what Trump’s fellifluous self could conjure up at any moment. There are a lot of tailwind risks to the US and global economy right now, but my take is they don’t necessitate cutting interest rates by the expected 0.5%. Especially not when in the first quarter of 2019, the US grew at a more than healthy clip of 3.1% annualised.
We’re about a decade on from the Great Recession, a time where an investment banking behemoth collapsed, credit froze over and consumer confidence sunk faster than Rory Stewart’s hope of being Prime Minister. That (or at least something close to that) is when you suck the last drops of juice from the interest rate mechanism. In my opinion, a time where economic stimulus in the form of, for example, cuts in corporation tax have (perhaps unsustainably) bolstered growth is not a good time.
Recent dovishness has led the US two-year yield to drop to as low as 1.82%, and cuts in interest rate could potentially inflate further already huge equity valuations. A dollar of an American company’s earnings has gone from setting you back around $15 to setting you back $22 or $31, depending on the data which you use. When Netflix shares dropped significantly on the back of decreased US subscribers, it may have indeed been a sign that valuations are becoming increasingly optimistic (and perhaps superfluous). Not to preempt any sort of bubbles which may be occurring in equity and broader asset markets, but signs such as this don’t really point towards much else. As any five-year-old child will tell you, inflate too much and the bubble goes “pop!”. And when the bubble affects millions of people’s livelihoods and could pose a huge threat to pensions everywhere, you really don’t want to inflate too much.
While Powell brings about legitimate concerns regarding slowing global trade and inflation, I question the need for any substantive change in policy at the present moment. Growth was frequently demeaned as laggard in the years following the 2008 recession, and it seems when economic growth finally picked up meaningfully, he thought it would continue for far longer than it did. Moreso, forward guidance can backfire, in signalling to investors that there’s some sort of grave boogeyman ready to jolt the US economy any time soon. In fact, this is simply not the case. Powell should save his best for when we’re far nearer to the trough of an economic cycle, when growth is closer to 0% than 3%, and the US labour market isn’t adding nearly as many as 224,000 jobs in June. Otherwise, he might find himself out of ammo, just when he needs it the most.