Donald Trump keeps an eye on Jerome Powell
History doesn’t repeat itself but it echoes quite loudly at times.
Financial markets have performed so wretchedly in recent months, even as the world enjoyed decent GDP growth, that investors and policymakers have become hung up on the question of whether they are now discounting a coming recession.
The Federal Reserve in particular has come under pressure from president Trump to pause policy rate increases, and looks to have bowed to a mix of this verbal assault and its own fears of potential instability from market volatility. It is now emphasizing how flexible it will be on further rate rises and attentive to new economic data.
Economists still struggle to see this recession, though. At the start of January, Citi, for example, revised down its global growth and inflation forecasts for this year, but only by tiny fractions. It now predicts global growth will be 3.1% in 2019, down from 3.2% previously, with inflation likely to come in at 2.4%, down from a previously expected 2.8%.
This is tweaking numbers at the edges: no big deal at all.
Maybe the explanation for sharply falling equity valuations and high-yield and investment grade bond prices is much simpler. It has little to do with either a recession or worries around US-China trade tensions or what Tariff man might say or do next.
Rather, we are now living through the aftermath of another debt bubble, but one of sovereign governments and central banks’ creation in the post financial crisis era, not one of private sector lenders as in the run-up to 2008.
Matt King, credit strategist at Citi, points to the $1 trillion decline in central bank purchases of financial assets in 2018 as the key to a sharp slowdown in credit creation, which had previously created marginal buying and driven up asset prices.
King suggests that when looking both at falling equity and credit markets, “the short-term correlations with central bank purchases are both astonishing and disturbing”. He argues: “The 2016-2017 surge in credit creation is now reversing.”
Ushered in front of the TV cameras on January 4, along with predecessors Ben Bernanke and Janet Yellen, to calm markets, Federal Reserve chair Jerome Powell indicated that he does not believe that the balance sheet normalization process “is an important part of the story of the market turbulence that began in the fourth quarter last year”.
However, this, rather than overly eager rate rises, may be a key mis-reading.
Chetan Ahya, global head of economics at Morgan Stanley, notes: “The Fed had anticipated that once it announced the path of balance sheet normalization, markets would discount that ‘passive and predictable’ pathway and that the process would be akin to ‘watching paint dry’.”
In fact, Ahya says: “The normalization process appears to have had a greater-than-expected impact on asset and financial markets via the portfolio balance channel.” He points out that shrinking the Fed’s balance sheet has produced cracks in various asset and credit markets, with US high yield credit spreads at their widest in 30 months, and financial conditions at their tightest in 17 months.
Stop the rot
It remains to be seen whether the Fed will now start to drop hints, perhaps as early as this week – its most recent minutes appear on January 9 – about adjusting the pace of its balance sheet reduction or even ending it early.
Matt King, Citi
King points out that that corporate leverage is near non-recessionary highs for issuers of dollar high yield bonds.
While decent profitability means that interest cover looks comfortable for now, investors should not be deceived by firms’ apparently high asset and enterprise values – derived from still exuberant equity prices – when set against their debts. They should be alert for further erosion in profit expectations.
How does King see this playing out in the bond markets in 2019? He points out that in recent years the big trade has been out of cash and into everything else: this year it may be out of everything and into cash. Rarely, he suggests, has a 3% yield on risk-free assets looked so good. However, by January 7 the yield on 10-year US treasuries had already come in to 2.65%, down from 3.23% just two months previously.
As the old joke among equity capital markets bankers when one of their deals bombed used to have it: “The price isn’t falling because there are lots of sellers: it’s just that there are no buyers.”
It’s conceivable that the Fed could ease if markets continue to fall, which might stop the rot and no doubt please Tariff man.
Unfortunately, it would also revive all the fears of secular stagnation.