Federal Reserve Chairman Jerome Powell testifies during a House Financial Services Committee hearing on “Monetary Policy and the State of the Economy” in Washington, July 10, 2019.
Erin Scott | Reuters
All eyes in the financial world turned to Capitol Hill this week as Federal Reserve Chair Jerome Powell gave his semi-annual testimony. In his opening statement Powell said, “It appears that uncertainties around trade tensions and concerns about the strength of the global economy continue to weigh on the U.S. economic outlook. Inflation pressures remain muted.”
What the markets heard was, “Ice cream for breakfast! Candy for everyone!”
The markets clearly believe a rate-cut regime is just around the corner, but is that, in the long-run, the best for the economy?
Pundits assert a rate cut is needed as “insurance” against a potential downturn in the economy foretold by the ongoing yield curve inversion. Although the widely watched 2- to 10-year part of the curve is still positive (though narrowing and now about 20 basis points) the 3-month T-bill has yielded more than the 10 year T-note for seven consecutive weeks after briefly inverting in March. The last nine recessions have been preceded by yield curve inversions. Yet over that time there have been ten yield curve inversions. In 1965/66 the yield curve inverted and there was not a recession immediately following.
History does not repeat itself, but there are similarities to today. Powell may be well advised to follow the path of his predecessor, William McChesney Martin, who stood firm against a president demanding monetary policy easing, and ultimately Chair Martin presided over the longest economic expansion in US history up to that time.
Presently, prices are stable and we are effectively at full employment: the dual mandate of the Fed. So why is Powell being accosted by the President and the markets demanding rate cuts? Shouldn’t we throw a parade and declare victory?
‘Crash and burn’
There are limits to monetary policy, as Powell noted when questioned by Rep. Hollingsworth this morning. Fiscal policy is needed to create growth and inflation. The president seems to measure the economy by the stock market, and the markets want low interest rates. When yield is scarce, there are no alternatives to stocks for investment, and as we all know, as demand increases, so do prices. Thus, lowering rates naturally leads to repricing the markets higher. The President has said that if Fed didn’t raise rates then the Dow would be up as much as 10,000 points. Honestly, that’s probably a pretty good guess – we would likely see a bubble develop and stocks trade at 25 times earnings. But bubbles burst. And as a long-term investor, I would much rather see slow and steady growth tied to earnings and balance sheet strength than a fast crash and burn.
History gives Powell one interesting precedent. In 1965, unemployment stood at 4.0% and inflation was 1.6%. In May of that year, then Fed Chair William McChesney Martin made a speech decrying a regime of “perpetual deficits and easy money” as creating an environment that could produce a bubble like that of the 1920s. President Johnson was furious, and in June asked his Attorney General Nicholas Katzenbach if he could fire Martin. (The answer, as repeated by Powell this week was “nope”.)
The yield curve inverted in December of 1965 with the 1-year T-note yielding more than the 10-year yield. The 90-day T-bill would soon follow. Faced with low unemployment, low inflation, and a hostile President who wanted lower rates, McChesney Martin advocated in December’s Fed meeting to raise rates. And the board voted 4-3 to do so.
Johnson’s anger reached a new level and on December 6, Martin flew to Texas to meet with the President. The often repeated and never denied legend is that when President Johnson and Chair Martin returned to Johnson’s ranch, the President physically assaulted Martin, pinning him up against the wall and demanding a change in policy.
Martin did not relent.
Creating a bubble
The yield curve remained inverted through 1966. A credit crunch ensued in August, leading to a decline in the Fed Funds rate, and at the end of the year, Martin’s Fed lowered the discount rate back to the mid-1965 levels. Yet the recession did not come. Indeed, inflation picked up to 2.6% and unemployment dropped to 3.8%. The yield curve moved positive in early 1967, and when a recession finally came (recessions will always come) in 1970, Chair Martin had presided over the longest economic expansion in U.S. history to date.
There are salient differences in the economy of 1966 to today, not the least that per capita GDP, in real terms, is roughly four times larger. Companies were aggressively expanding capital expenditures in 1966 in spite of rising rates then, while they are continuing to delay capex today in spite of declining rates. Yet, the central lesson of 1966 might be relevant: The Fed should remain independent, and regardless of pressure from the markets, from corporate America, from the President, and now from the punditry, follow the data for the best long-term interests of the economy and the country.
My concern (not prediction, but concern) is that a July rate cut in the face of a still healthy economy will create the exuberance and bubbles from which crashes, and crises, arise. Rather than expecting monetary stimulus to generate more business investment, it’s more realistic to think that interest-rate cuts will cause higher asset prices and more debt. Recessions are caused by financial imbalances and a rate cut could be the trigger for a recession rather than insurance against it.
We all want candy. But Uncle Jay might need to keep the jar locked up for our own good.
experts predict more pound weakness
The currency initially fell for a third day running during morning trade, plunging a further 0.4% against the dollar to reach a 27-month low. Investor jitters center around concern that Johnson could pull the U.K. out of the European Union without a formal deal in place.
But immediately after Johnson was announced as the country’s next leader, the pound pared its losses to trade around the flatline at $1.2474. Johnson’s rise to power had largely been priced in by the markets and the announcement meant one rung of uncertainty had been removed.
Johnson will deliver his maiden speech as prime minister outside 10 Downing Street on Wednesday. On Tuesday, Johnson struck a compromising tone, promising to “unite the country,” but reiterated calls for optimism on the prospect of the U.K. leaving the bloc.
Michael Brown, a senior analyst at Caxton FX, said his focus would quickly switch to the next steps: “Namely, Cabinet appointments and the Brexit plan. The latter will be of more importance for markets, with sterling set to remain under pressure should Boris continue his ‘do or die’ Halloween Brexit stance.”
Britain’s National Institute of Social and Economic Research (NIESR) published a report on Monday which suggested that there is now a 40% chance of a “no-deal” Brexit on October 31, an event anticipated by many to be profoundly damaging for the British economy.
Johnson has vowed repeatedly to take the U.K. out of the EU with or without a deal in place, while also rejecting the existing Withdrawal Agreement negotiated by his predecessor Theresa May, and pledging to return to Brussels to seek new terms.
In the past week, as 160,000 Conservative Party members cast their ballots to elect the country’s next leader, both Johnson and rival Jeremy Hunt hardened their stance on the Irish backstop clause insisted upon by Brussels, therefore increasing the likelihood of a no-deal departure.
In a recent note, Berenberg senior economist Kallum Pickering raised the risk of a hard Brexit — in which the U.K. exits both the EU’s customs union and its single market to trade on World Trade Organization terms — to 40%, making it Berenberg’s base case.
However, as Pickering pointed out, Johnson has a reputation for adapting his rhetoric to changing tides of political sentiment. A Conservative member of the House of Lords, Michael Heseltine, once described Johnson as “a man who waits to see the way the crowd is running and then dashes in front and says ‘follow me’.”
Speaking to CNBC Monday, Pickering said an unresolved Brexit was like a “kidney stone lodged in the abdomen of the British economy,” and projected greater sterling weakness until a resolution is found.
In a further note Tuesday, Pickering suggested that Johnson’s promise to scrap the Irish backstop from the Withdrawal Agreement may just be a high-risk negotiating strategy, with a low chance of success, to push for compromise from Irish Prime Minister Leo Varadkar to accept a half-way deal. If the EU refuses Johnson’s demand, Pickering predicted, moderate British lawmakers could move to thwart a no-deal exit, setting the stage for a “major showdown in Parliament” in the fall. This could lead to a further Brexit extension, a snap election or a second referendum.
“While Johnson may be forced to take a more pragmatic line eventually, we do not expect him to use soft words on Brexit in his first speech,” Pickering wrote on Tuesday.
“In the not-unlikely event that he doubles-down and appears to harden his Brexit stance further, U.K.-oriented equities and sterling would likely react negatively.”
Boxed into a hard Brexit
Two further developments suggest that the hard Brexit risk has increased. Ahead of his anticipated coronation, Johnson has been surrounding himself with hardliners likely to box him into pursuing the exit door on Halloween come what may. As he begins to name his Cabinet this week, the extent of the euroskeptic makeup of his ministers could further impact the currency.
Meanwhile, the main opposition Labour party is sliding in the polls, rendering it a lesser threat in the event of a snap general election and potentially leading moderate Conservative members of parliament (MPs) to back no deal, in order to protect their seats from the surging Brexit Party.
The odds of an election in the fall are rising sharply. Stephen Gallo, European head of FX strategy at BMO Capital Markets, said in a note Monday that Johnson will have an “incredibly narrow window of opportunity” to exploit Labour’s vulnerability, cut a deal with the Brexit Party to preserve Conservative seats, and lay out a post-EU and domestic policy agenda.
“That window starts to close rapidly by the end of the year, and there is no telling what 2020 will bring without a new parliamentary arithmetic for the Tory (Conservative) leadership to work with,” Gallo said.
“We still believe there is more GBPUSD weakness to come.”
Kamal Sharma, director of G-10 FX strategy at Bank of America Merrill Lynch, said the combination of Brexit factors weighing on the U.K. economy meant a potential “flash crash” for sterling could not be ruled out.
“The current account deficit has been the Achilles heel for the U.K. for a number of years now. Historically, the U.K. has been a very big recipient of FDI (foreign direct investment),” he told CNBC’s “Squawk Box Europe” on Monday.
“It’s now becoming more of a net debt story, so if investors start to suddenly give up on the U.K., for example, given the liquidity situation of sterling already, that really opens us up to a potential flash crash.”
Things can only get better
However, not all analysts were quite so pessimistic. Giles Keating, senior advisor at Torchwood Capital, told CNBC Tuesday that most of the bad news is already priced into sterling and investors could “start to look forward.”
“What do you look forward to? Fiscal expansion — can the Bank of England react to a big fiscal expansion by cutting interest rates? It doesn’t seem to me to make sense. That debate could end up being to hold rates here at a time when others were cutting them,” he told CNBC’s “Squawk Box Europe.”
“The Bank of England is looking at an economy where wages are accelerating. The latest wage rises are really moving up sharply, we had the National Institute warning yesterday of 4% inflation as a risk — the Bank, in my mind, can’t cut against that background.”
Europe is at odds over who will replace Christine Lagarde at the IMF
International Monetary Fund (IMF) managing director Christine Lagarde speaks during a press conference in Tokyo on October 4, 2018.
Kazuhiro Nogi | AFP | Getty Images
European officials are still scratching their heads over Christine Lagarde’s successor at the International Monetary Fund (IMF), according to several people with knowledge of the discussions, with no standout candidate for the role.
Lagarde is due to start her new job as president of the European Central Bank (ECB) in November, leaving the IMF’s chair empty. In Europe, EU member states agree that the next IMF managing director needs to be from the continent — but they’re struggling to rally behind one particular name.
“The truth is that there is no readily available tried and tested European all-rounder,” a European minister, who did not want to be named due to the sensitive nature of the talks, told CNBC.
There is no official shortlist of candidates, but many governments of EU nations have put forward a name to take the top job. Some of the non-official candidates are:
- Jeroen Dijsselbloem, former Dutch finance minister and president of the Eurogroup (which brings together the 19-euro zone finance ministers).
- Mario Centeno, the Portuguese finance minister and currently Eurogroup chief.
- Nadia Calvino, the Spanish finance minister.
- Olli Rehn, central bank governor of Finland and former European commissioner for the euro.
- Mark Carney, the current governor of the Bank of England — a Canadian citizen who also has Irish and English passports.
- Kristalina Georgieva, from Bulgaria, who is currently serving as chief executive of the World Bank.
- Mario Draghi, the outgoing ECB president.
According to two other European officials, who also preferred to remain anonymous, none of the candidates have the right profile at this stage. Some names also don’t have enough experience or they are not liked by certain governments due to their political affiliation, their past comments or their background, the officials told CNBC. Since the IMF’s formation back in 1945, the managing director has always been from Europe.
There is also an age restriction to deal with. The IMF’s rules state that managing directors must be under 65 years of age when appointed and cannot serve beyond their 70th birthday. As such, the chances of certain candidates, such as Kristalina Georgieva, become much smaller.
“If (the) age limit is adapted to today’s realities, there is Georgieva and Draghi,” the European minister told CNBC.
France, who’s chairing the discussions across the different EU capitals, is reportedly looking at ways to change the laws. However, it is unclear whether that idea would be approved inside the IMF.
A source within the French government told CNBC that Paris “does not have a preferred candidate and will play its coordination role impartially.” Meanwhile, a separate EU official confirmed to CNBC that the aim is to have an agreement by the end of the month.
EU has 35 billion euro list ready if US hits EU cars: EU trade chief
European Commissioner Cecilia Malmstrom holds a news conference in Brussels, Belgium March 7, 2018.
Eric Vidal | Reuters
The European Union would retaliate with extra duties on 35 billion euros ($39.1 billion) worth of U.S. goods if Washington went ahead with tariffs on EU cars, the bloc’s trade chief said on Tuesday.
“We will not accept any managed trade, quotas or voluntary export restraints and, if there were to be tariffs, we would have a rebalancing list,” European Trade Commissioner Cecilia Malmstrom told a committee of the European Parliament.
“It is already basically prepared, worth 35 billion euros. I do hope we do not have to use that one,” she continued.
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