Rate cuts were unnecessary in a shutdown economy

Introduction

As a consequence of the Covid-19 pandemic and the potential catastrophic impact on the global economy, the Fed slashed interest rate to zero in March after four years of effort to increase its benchmark rate. In addition, it has also increased drastically the size of its balance in order to prevent the whole market from collapsing; the Fed’s balance sheet is now expecting to grow to USD 8/9 trillion by the end of the year, twice more than the high reached in October 2014. Even though there is no question that the whole economy was healthier this time than prior to the Great Financial Crisis and that the Fed’s interventions and liquidity injections were timely and mandatory to save the whole market, we believe that the rate cuts were unnecessary.

A slowing economy pre-virus

As we know, the US economy peaked in the last quarter of 2018 and was already considerably slowing down in 2019 due to the high uncertainty in the market (Brexit, followed by the China-US trade war). Figure 1 (left frame) shows the global and US manufacturing PMI overlaid with the US 10Y yield. After the global economy peaked in Q4 2017, the outperformance of the US relative to the rest of the World in 2018 led to a rising USD and a rising 10Y yield, but eventually the slowdown of the US economic growth brought the long-end of the Treasury curve to the downside.

In addition, the sharp sell-off in equities in Q4 2018 (nearly 20 percent from peak to trough) reversed the Fed’s policy guidance with the famous ‘Powell pivot’ from ‘a long way from neutral’ in October 2018 to ‘appropriate stance in January 2019. Policymakers even cut rate three times in the second half of 2019 in order to stimulate demand after the 2Y10Y yield curve inverted in August.

Figure 1

RR1Source: Eikon Reuters, Bloomberg

Hence, the reversal in global central banks’ policy (from global tightening to global easing) combined with the significant increase in global liquidity led to a sharp recovery in stocks, with the SP500 recording one of its best year in the past 30 years (figure 2, right frame). However, the 2020 events generated a global panic and equities sold off aggressively in February/ March amid concerns of the global supply shock will soon spill over demand. Did the Fed increase volatility at first by just cutting interest rates to zero? Even though we understand that policymakers globally wanted to quickly reassure markets by hinting participants that it will not let the whole market fail, there has been very few debates on whether rate cuts are useful in a shutdown economy. In theory, rate cuts should decrease the incentives to save and increase demand for credit and the incentives to consume. We think that the massive liquidity injections would have been enough this time to halt the global panic and that policymakers should have save the little room left in the benchmark rate for later (i.e. when the economy reopens). In addition, we believe that the aggressive rate cuts may have increased price volatility in March; figure 2 (right frame) shows that stocks tend to sell rapidly in when Fed cut rates aggressively.

Figure 2

RR2Source: Eikon Reuters

US shadow rate to hit -5 percent in 2020

Even though some economists have been speculating that the Fed will adopt a negative interest rate policy (NIRP) in the coming months as a response of the Covid-19 crisis, we are not convinced of that and we think that policymakers will first wait and see if the massive liquidity injections will be enough to stimulate the economy. Figure 3 shows the historical path of the Fed Funds rate since 1960, including the ‘shadow rate’ based on Wu-Xia calculations (2015),a tool that researchers have proposed in recent years to estimate how low would the benchmark rate be had the the Fed not used unconventional monetary policy.

This time, the shadow rate is expected to fall down to -5% by the end of the year, 2 percent lower than the -3 percent low reached in the third quarter of 2014 (due to QE3), which should in theory represents a massive stimulus for the economy.

Figure 3

Source: Eikon Reuters, Wu-Xia (2015)

Key economic measures such as r-star have become less relevant in the past cycle

Unlike most of the central banks, the Fed follows a triple mandate when conducting its monetary policy, which is to achieve the following goals: maximum employment, stable prices and moderate long-term interest rates. In addition, policymakers have tried to estimate the dynamics of the (unobservable) neutral rate of interest, r-star, which can be defined as the interest rate that supports the economy at maximum employment while keeping stable prices. Figure 4 (left frame) shows the relationship between r* (estimated by Holston et al. (2017)) and the implied Fed Funds rate (including the shadow rate). Policymakers’ have usually immediately been reacting by lowering the FFR when the r-star was starting to decrease due to an economic shock / recession.

We do not have the recent Q1 updates for r-star, but it is fair to say that it will decrease drastically, which would support the argument of a lower FFR. However, the Fed should just have increased the size of its balance sheet this time (which would have lowered the shadow rate) while keeping extra room for FFR intervention in the coming months when economies reopen.

In addition, we can also see that the relationship between the implied FFR and the US saving rate has broken down in the past cycle (figure 4, right frame). Before 2008, lower FFR was usually leading to a lower saving rate in the following 2 to 3 years (lower rates decrease the incentive to save and should increase the incentive to consume). However, since 2009, while interest rates reached the lower bound and even decreased if we look at the shadow rate, the saving rate has increased. The saving rate could actually go even higher given the uncertainty that households will face post lockdown.

Figure 4

RR4

Source : EIkon Reuters, Holston et al. (2017), Wu-Xia (2015)

In short, more rates cuts are useless in a shutdown economy; policymakers should leave some room for later in case of a ‘Wsss – shape’ recovery.

 

January 2015: A Rough Start

The past month has been quite eventful in the financial market and I am sure that some of the decisions (if not all) surprised many of us. After the SNB announce on January 15th, the ECB took over and unveiled a €60bn monthly QE (not open-ended) through September 2016; so 19 months at €60bn equals €1.14tr. The ECB, which has already been buying private assets such as covered bonds (a safe form of debt issued by banks) and ABS, will add an additional €50bn worth of public debt (bonds of national government and European institutions) to its current program starting in March this year. The purchases of these securities (in the secondary market) will be based on the Eurosystem NCB’s shares in the ECB’s capital.
In addition, President Draghi also added that the ECB will remove the 10bp spread on the TLTROs, and the interest rate applied will be equal to the rate on the Eurosystem’s MRO (5bp).

We saw on Friday that EZ preliminary inflation fell by 0.6% in January after a -0.2% print in December, the largest decline since July 2009 when prices also fell 0.6% following GFC.

The ECB decision(s) sent the Euro to newest lows last week, down to 1.1120 (11-year lows) against the greenback and below the 0.75 level (0.7440) against the pound. But more importantly, it sent a bigger amount of government debt in the negative territory (yields). According to JP Morgan, there is currently (approximately) €1.5tr of Euro area government bond with longer than 1-year maturity trading at negative yields over time, and a ‘mind-blowing’ €3.6tr of global government bond debt (nearly a fifth of the total) with negative yields as the chat below shows us. For instance, the entire 10-year Swiss curve is  now negative.

Global NIRP(Source: JPMorgan)

Another interesting topic is of course the 3 consecutive rate cuts (in 10 days) by the Danish Central Bank, that lowered it deposit rate to a record low of -0.5% to defend its peg and keep the Danish kroner (DKK) close to 7.46 per Euro (ERM II since 1999). EURDKK went down below 7.43; we will see this week how much policymakers spent in January in order to counter a DKK appreciation (some reports estimated that the central bank had to sell more than DKK 100bn). As a consequence (of the NIRP policy), a local bank – Nordea Kredit – is now offering a mortgage with a negative interest rate.
I believe the Danish krone is a currency to watch (in addition to the CHF) this month if the situation in Greece deteriorates.

A Weak Swiss Franc…
Since the SNB surprise, the Swiss has remained weak against the major currencies, with USDCHF up 7 figures  (trading currently at 0.93) and EURCHF up from parity to 1.0550. Analysts slashed their forecast for this year and are now predicting a recession (-0.5% according to the KOF Swiss Economic Institute). I like the chart below which shows the 12-month Probability of the top 10 countries to fall into recession in the coming months according to Bloomberg economist surveys.

Probarecession(Source: Bloomberg)

Japan and JPY still under threat over the long-run
In Japan, the 10-year JGB yield rose by 9bp in the last 10 days and is now trading at 29bps. USDJPY tumbled below 117 overnight on Grexit comments and Chinese manufacturing PMI contraction in January (49.8 vs. 50.2 expected), breaking its 117.25 support and extending its trading range to 116 – 118.75. ‘Buyers on dips’ reversed the trend and the pair is now trading at 117.60.
If we look at the long-run perspective in Japan, late macro indicators showed us that Abe’s government will have to do more. Real wages are still declining and fell the most in almost 5 years and the economy has now entered in a triple-dip recession (0.5% contraction QoQ in Q3). On the top of that, inflation has been weakening for the past 8 months as energy prices (mainly weak crude oil) weight on Japanese core inflation rate.
In addition, we saw that Japan plans a record budget deficit for next fiscal year (starting April 1st 2015) to support the economy. FinMin Taro Aso reported that government minister and the ruling coalition parties approved a 96.34tr Yen budget proposal for FY2015/2016. And I believe that we haven’t reached the peak yet, as Japan’s aging population (i.e. increasing social security spending) will ‘force’ the government to print larger and larger deficits. The IMF predicts that the country’s debt-to-GDP ratio will increase to 245% in 2015. It clearly shows that the USDJPY trend is not over yet, and there is further JPY weakness (and USD strength) to come.

On the other side of the Pacific Ocean, the US economy cooled in the fourth quarter. After the 5-percent Q3 print, GDP expanded at a 2.6% annual pace in the fourth quarter (first estimate). Net exports was the largest detractor from Q4 GDP (-1.02%) as imports grew faster than exports. King Dollar continues to benefit from the global weakness with the USD index trading slightly below 95. The equity market still handles the Fed’s withdrawal from the Bond Market with the S&P500 trading around 2,000 (looks like it is out of energy though), while US Treasury yields are compressing to new lows. The 10-year and the 30-year yields are trading at 1.67% and 2.25% respectively (which is quite concerning), and it seems the trend is not over yet. In regards to the inflation rate (that plummeted to 0.8% in December), the Fed delivered a hawkish statement last Wednesday (‘strong jobs gains’, ‘solid pace’ for economy), however dropping the entire ‘considerable time’ sentence and adding ‘inflation is anticipating to decline further in the near term’. The implied rate of the December 2015 Fed Funds futures contract is trading 30bps lower at 41 bps, while the December 2016 implied rate decreased by 60bps to 1.05bps in the past 6 weeks.

An important topic to follow this month will be developments in Greece which are moving very fast since the election on Sunday (January 25) and Syriza’s victory. ECB council Member Erkki Liikanen said over the week end that Greece needs to negotiate a deal before February 28th (when the Greek support program EFSF expires after the 2-month extension approved in December).