Fed talks soft

So the Bank of England didn’t change UK bank rate this week. There was some stuff about the increased risk of a no-deal Brexit, but we’ll revisit that another day!

Nor did the Federal Reserve cut US interest rates, despite all the rumours. In response, neither the dollar nor the stock market did, well, very much.

As a result, was the latest news from America’s central bank – in one of the most keenly-awaited Fed announcements for years – rather an anti-climax?

In fact, the statement’s hints of future rate cuts were more or less what financial markets wanted to hear.

But these may not be enough to stop both a recession and a stock market slide…

Losing patience

Since the great financial crisis of a decade ago, central bankers around the world have commanded much more attention than they used to.

The US Fed, though, has been setting the tone for everyone else. Which is why all eyes focussed on it this week.

Or to be more precise, it was the US interest rate-setting Federal Open Market Committee (FOMC) that everyone was watching on Wednesday following the conclusion of its June meeting.

Yet while the FOMC decided to maintain its key policy in the 2.25% – 2.5% range, the language in its statement (the minutiae of which are pored over by armies of financial analysts) softened to ‘dovish’.

Staying “patient” in monitoring economic data has been shelved. And “uncertainties about [the] outlook have increased”, meaning that the US central bank “will act as appropriate to sustain the expansion”.

This is Fed code for ‘we’re thinking about reducing rates next time’. Indeed, market chat is that at least two rate reductions are now expected during the second half of 2019, with at least 1% being cut from borrowing costs over the next 12 months.

Looks like Donald Trump’s criticism of the US central bank has hit home.

Traditionally, US Presidents don’t get involved in Fed decisions. But when did Mr T ever do anything traditional? Talk has even just emerged about him trying to replace Fed boss Jerome Powell!

Certainly the President has made it clear for some while that he wants lower rates. And he expects the Fed to deliver them. After all, they’d clearly help his 2010 re-election campaign by giving the US economy a boost.

The problem is that a few rate cuts may not do the trick.

Economic woes loom

The message from the bond markets is that economic trouble is in store.

Global yields on sovereign debt are plummeting. In other words, government bond prices are surging around the world.

Indeed, in several countries, long-term interest rates are dropping into negative territory once more. And this isn’t just happening on a real (i.e. inflation-adjusted) basis, but in absolute terms.

Starting with UK government bonds: 10-year gilts are now yielding a mere 0.8%. That’s totally derisory versus historical standards.

With the UK CPI inflation running at just 2% annualised, just under its highest level this year, current buyers of 10-year gilts are losing more than 1% a year after allowing for the rising cost of living.

10-year US Treasuries yield just over 2% after falling further on the Fed’s announcement. But with May’s year-on-year inflation rate standing at 1.8%, down from 2% in April, there not much scope here either for generating any real income.

And the picture is even worse elsewhere.

The yield on 10-year bunds (German government bonds) has plunged to a record low of -.32%. Put another way, it now costs you around 0.3% per annum to hold securities such as these.

And lending money to the government in neighbouring Austria will, for the first-time ever, cost you cash. Ditto Sweden. Even in Poland, 10-year state bonds currently pay you a miserable 0.1% a year.

Now this isn’t due to critiques from Donald Trump. Nor is it more central bank money-market meddling (not yet awhile, anyway!) Nor have all the governments in these countries suddenly become paragons of financial rectitude, which would reduce their need for funding and also the rates they’d need to pay to raise this.

Yield curve warning

What we’re seeing here are genuine fears about looming recession/deflation, in which not only the demand for money, but also the price paid for it, will drop.

That’s backed up by the deterioration in the Citi Economic Surprise Index that tracks official data releases. In other words, for several months the economic news that has emerged is proving to be worse than had been expected.

I recently mentioned the imminent yield curve inversion. That’s when borrowing money over longer timeframes costs less than over shorter periods, which is a clear signal that a recession is around the corner. This is happening right now.

But there’s one final development that we still need to witness. Over to the estimable Societe Generale global strategist Albert Edwards:

“There is an earthquake happening in global bonds”, he says. “We should now watch for curve steepening (this occurs just before recession starts as central banks cut policy rates) as a prelude to imminent recession. If the US has already slipped into [one], what price yields heading way below zero before the recession ends?”

Meanwhile, all this rate action is being accompanied by still rising stock prices. The S&P 500 is has just hit a new all-time high.

Until the start of 2019, equity indices moved in line with long bond yields. The more the latter rose – implying greater demand for money and increasing economic activity – the higher stocks went.

But equity investors now see falling bond yields as a signal to buy more shares. Sure, they reckon, profits may decline in a recession. Yet they believe it’s worth paying a higher valuation for what’ll be left on the earnings front.

That’s classic bull market thinking. Yet from my standpoint, it feels like share prices are still trying to defy bond yield gravity. And that can’t go on forever…

Many thanks for all your past comments. If you’d like to say anything about this piece, or indeed on anything else, please send it to: ukuncensored@agora.co.uk.

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