Toxic politics push rates lower
This week the ten-year US Treasury bond yield fell to 2.09 per cent, its lowest level in twenty months as interest rates in Europe continued to plunge and President Trump threatened Mexico with new tariffs. With Brexit negotiations caught in a seemingly endless quagmire and Washington intent on reversing decades of global economic co-operation to the detriment of its own citizens, investors are paying up for safe assets.
Dysfunctional politics on both continents threatens any hope of preventing the global growth slowdown already in progress and that's causing investors to demand safety above all else. In Germany, the privilege of lending to Europe's largest economy will cost you 0.2 per cent. And now Europe's negative interest rates are feeding into the US bond market helping push yields lower.
Increasing evidence of a sluggish American economy has investors looking for a rate cut despite some Fed indications to the contrary. While the first quarter 2019 US GDP report showed a revised real GDP increase of 3.1 per cent, the headline number belies less activity at a deeper level. After adjusting for inventory accumulation and reduced import spending the economy grew at an annualised rate of just 1.5 per cent, or about half of last year's 2.9 per cent level. For 2019 as whole, economists are forecasting a growth rate of 2.6 per cent followed by a deceleration to 1.9 per cent in 2020.
Interestingly, higher tariffs on imports coming into the US were meant to make American manufacturing more robust, but the opposite has been occurring. The April Institute for Supply Management survey fell to its lowest point since October 2016. The ISM report queries managers about whether business conditions are improving and measures variables such as production levels, material purchases, new orders, order backlogs, employment and inventories. Those readings were consistent with weaker orders for durable goods which were down 0.1 per cent in April from a year earlier, the first annual decline since 2017.
Meanwhile, growth outside the US appears to be slowing at an even faster rate with Europe continuing to stagnate and Asia bearing the brunt of the ongoing trade war pain. Even Australia, which has avoided an economic recession for decades was forced to cut interest rates this week to historic lows.
The escalating trade war with China, decelerating global growth and the uncertainties caused by a tweet-driven political climate have investors making increasing bets the Fed will cut rates as early as this September. In fact, the Fed funds futures market suggests America's central bank could reduce rates more than once before the end of the year.
After the latest breakdown in the US-China trade talks, the futures market now shows an 89 per cent chance of the Fed cutting rates by September and a 34 per cent chance of two rate cuts by year-end. Meanwhile, the longer end of the US Treasury curve has declined sharply with the ten-year yield falling from around 2.6 per cent to 2.08 per cent over just the past few weeks.
The yield curve is also inverted at the front end, meaning investors are willing to accept a lower rate of interest on longer-term maturities than shorter ones. This represents a phenomenon which usually occurs only when investors expect interest rates to be lower in the future.
Following eight successive increases over the past few years, a rate reduction would mark a sharp reversal in US monetary policy. Such an event is being referred to as an “insurance cut”, or one which might keep the Fed ahead of the curve if indeed the world's largest economy begins to face a significant slowdown, or worse.
It all seems a bit surreal when just eight months ago, chairman Jerome Powell was determined to push interest rates higher, publicly stating last October that the central bank was “a long way from neutral”. The so-called “neutral rate” is the theoretical level which neither hinders the economy nor causes it to overheat.
With increasing pressure from the White House and signs of lower inflation, fixed income and futures markets are suggesting a policy reversal sometime this year. Importantly, inflation has declined from 1.95 per cent at the beginning of the year to 1.6 per cent in the latest month as measured by the Personal Consumption Expenditures index. Lower inflation generally gives the Fed more room to ease credit. However, the falling headline number for the Fed's preferred inflation measure does make a rate cut certain. The Fed also considers the level of employment which is presently looking strong.
Although Powell was criticised for ignoring the lower inflation data following a recent FOMC meeting, he has generally been sticking with his guns, declaring the decline in inflation has been just temporarily depressed and caused by “transitory” factors. Moreover, Powell was not alone in his thinking as other FOMC members including Fed vice-chairman Richard Clarida chimed in with similar statements. Even after recent data showed core inflation well below the Fed's 2 per cent target, Mr Clarida said the central bank remains “at or close to” its mandated goals of maximum employment and stable prices.
Meanwhile, US political leadership seems committed to destroying wealth by impeding trade and attacking its own technology stalwarts including Amazon, Facebook and Alphabet, parent company of Google. While, slower growth may not necessarily lead to an imminent Fed rate cut the odds are steadily rising. For example, if the ongoing trade war denigrates into a full blown “Cold War” akin to the US-Soviet Union conflict of decades past, America's central bank may have no other options.
The first salvo towards this outcome may have been Trump's recent threat against Mexico last week, effectively using tariffs to enforce immigration policy. Watch next for implementation of tariffs on the additional $300 billion in goods imported from China which has so far been withheld.
• Bryan Dooley, CFA, is the senior portfolio manager and general manager of LOM Asset Management Ltd in Bermuda. Please contact LOM at 441-292-5000 for further information. This communication is for information purposes only. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument, investment product or service. Readers should consult with their Brokers if such information and or opinions would be in their best interest when making investment decisions. LOM is licensed to conduct investment business by the Bermuda Monetary Authority