The dollar’s status as the world’s reserve currency and the vast US government bond market ensures the Federal Reserve’s status as the dominant central bank. Its policy decisions and guidance matter immensely, particularly for emerging market economies that have plenty of dollar-denominated debt to service.
A U-turn on monetary policy this week from the Fed has been billed by some as a twin capitulation to both financial markets and President Donald Trump’s incessant demands that it should stop raising interest rates.
Such critiques miss the burning issue: a decade after the financial crisis, the global economy is slowing much faster than expected, and debt levels have ballooned, particularly in EM and in the corporate world. Many investors still pin their hopes on Beijing stimulating economic activity this year, but do so as China is enduring a credit crunch and trying to prevent a trade war with Washington.
With this backdrop, it’s hardly a shock that in just over a month the Fed has switched from signalling further rate increases to this week’s emphasis that patience is now its watchword.The Fed’s commitment to a patient approach towards interest rates and the willingness voiced this week to consider stemming the speed at which the balance sheet is shrinking mean the central bank is now sitting on the sidelines. Moderating inflation pressure helps provide it a cover to do so even while, as this week’s employment report reminded everyone, the US jobs market remains healthy.
Instead of seeing the Fed’s pause as a cave-in to the recent market turmoil, investors should focus on what made policymakers reverse course so quickly. Aside from economic weakness in China, the eurozone and Japan, the Fed faces a US economy experiencing signs of late-cycle weakness, especially in housing. At the same time, corporate earnings growth expectations for the first half of this year have been cut significantly to the low single digits.
Given the mammoth scale of corporate borrowing in recent years, the ability of companies to grow their earnings has been a critical cushion. It’s a cushion that is now deflating. The large drop in corporate bond prices during December’s rout appears to have left a mark with the Fed, as it should. US stocks may have enjoyed their best January since 1987, but the premium investors are demanding to buy credit has widened sharply over the past 12 months and remains near a level seen in 2016, according to the Moody’s BAA index.
The Fed’s actions this week amounts to a ratification of the concerns that markets flagged during a turbulent fourth quarter last year. Listening to markets and detecting signs of trouble before they hurt the broader economy is exactly what central banks should do. There’s plenty of justified criticism about the Fed failing to appreciate the extent of the mortgage and credit bubble that some saw building before 2007. My question to a Fed official in May that year about the sharp rise in repo funding via banks that left them very reliant on short-term funding was dismissed at the time as a poor way to gauge the leverage within the financial system.
Asset prices matter for modern economies that function thanks to hefty amounts of borrowing. Since the US central bank’s former chairman Alan Greenspan initiated the now famous “Fed Put” with rate cuts after Black Monday in 1987, policymakers have remained ever ready to step in and support markets. This happened in 1998, then during 2001 and again after 2008 with the new ammunition of quantitative easing.
Creating breathing room for global markets is usually achieved via a weaker dollar. And judging by the bullish response in emerging markets, the Fed has helped China this week. With the renminbi touching a six-month high on Thursday, there is scope for China to ease interest rates without unleashing a much weaker currency that would only complicate Beijing’s stimulus efforts.
Clearly, Fed officials are worried by market turmoil infecting the broader economy. They are also concerned about clouds in the form of trade frictions, China’s financial crunch, high levels of corporate leverage, lacklustre US earnings growth and Brexit. The coming weeks should offer more clarity on trade, as well as on the health of the US and global economies. In this context, Treasuries and other major sovereign bond markets will be important barometers to watch.
The US bond market is doing more than telling us that the Fed has just paused; it’s suggesting that the central bank is at the very early stages of a pivot towards the next easing cycle. This week yields on the two and five-year notes dipped below 2.50 percent, the upper band of the current overnight federal funds rate.
Lower yields in developed world bond markets will support risk assets and, together with a weaker dollar, there are already signs of money chasing high-yielding EM currencies as the carry trade finds a renewed spring in its step.
What should give investors pause for thought is a further decline in top-tier bond yields and inflation expectations, which would suggest the Fed has misjudged the cycle and already tightened policy too far. As seen during the second half of 2000 and 2007, US Treasury yields do send a message that deserves to be listened to.