Market Commentary for October 2019

"Interest rates and the elephant in the room... "

By Alan Hull

This commentary is in part or entirely created using extracts and comments from my weekly Blue Chip Report. For more information about the Blue Chip Report, including subscription details and a recent sample report, go to Blue Chip Report

Last month saw the U.S. Federal Reserve lower their target interest rate and our Reserve Bank followed suit this week...surprise, surprise. Anyway as a backdrop to this discussion, this is what I wrote about the Federal Reserve's actions back on Friday the 20th of September...

The U.S. Federal Reserve met this week and the Chair, Jerome Powell, gave a press conference at the end of it. He announced a 25 basis cut to the Fed’s interest rate target to a range of 1.75 to 2.00%. He announced said interest rate cut shortly after stating what good health the U.S. economy was in. It was in good health and expanding at an acceptable rate.

It was expanding mainly because of domestic consumption and whilst I will shortly take issue with this, there’s actually no need because Jerome gave the game away himself. He went on to say that U.S. production/manufacturing was in the doldrums and there was a reduction in business investment due to general uncertainty & volatility.

This uncertainty and volatility was due to heightened tensions in foreign trade, which had become considerably worse since the last meeting of the FOMC in July, when they also cut the target rate by 25 basis points. On that occasion Jerome stated that the rate cut was a one off and that it should not be seen as the start of an easing cycle. So much for that forward guidance!

Now I will digress for a few paragraphs to explain why economic expansion driven by consumption is something of a furphy. Conventionally, when an economy is doing well, driven by productivity, it leads to more people working and therefore spending more money. This increase in consumption creates demand for goods and services and this drives productivity.

This is a healthy economic cycle where productivity is the engine room. But consumption can be driven by forces other than strong productivity and general prosperity. It can also be driven by credit and this is encouraged by having low interest rates and lots of money in circulation. So when an economy needs a helping hand, creating ‘synthetic’ consumption by fiddling with these monetary levers is liking giving a dying patient adrenalin or electric shock treatment.

Of course the global economy has been receiving this adrenalin now for over a decade and the U.S. Federal Reserve is at the center of this monumental policy blunder. So I think Jerome just wanted to start his press conference on a positive note, but it was a rather comical overture…

‘Ladies and gentlemen the U.S. economy is in good shape and expanding nicely… and so we are going to lower the already ridiculously low FOMC’s target interest rate by another 25 basis points. Just as a bit of added insurance for the economy’

And hence Jerome gave the game away by going on to admit that the U.S. was suffering weakening production & exports and a reduction in business investment. Of course some economists think that targeting consumption with monetary policy is a sustainable approach, where I think it is as stupid as targeting inflation… but that’s another discussion.

Anyway back to my earlier thread and Jerome was obviously referring to the heightened tensions between the U.S. and China when he was referring to ‘foreign trade’. And he very diplomatically used the words ‘volatility’ and ‘uncertainty’ in reference to Trump tweets. He also threw in some other external factors for good measure such as the growing Brexit debacle.

So this was all reason for the Federal Reserve to lower their target interest rate by another 25 basis points after saying at the last meeting that it was unlikely. Thus, Jerome stated that this move was an effort to ‘shore up’ the U.S. economy given these latest developments, which is aptly described as an insurance policy rate cut. And I think it’s wafer thin reasoning.

Could it be that Jerome and the FOMC are actually giving way under Trump’s bully boy tactics for lower interest rates? Jerome is not a very good orator insofar as he has some tells whenever he is uncomfortable, and he was uncomfortable a few times in the press conference. And he’s not the first Fed Chair to be bullied by a U.S. President. Arthur Burns was bullied into adopting an easing approach to monetary policy by Nixon. This ultimately led to the 1970s inflation.

But all that aside there is another glaring issue here…U.S. monetary policy is now being used to offset U.S. fiscal policy. In contrast our Reserve Bank Chair, Philip Lowe, recently took a swipe at the Federal Government saying that the RBA could not be expected to do all the heavy lifting when it came to stimulating the Australian economy. This was probably as close as the separation of powers would allow Philip to go. And good on him for doing so.

What frightens me about the U.S.’s monetary policy being used to counteract fiscal policy is that it plays into President Trump’s hands. He came out with a predictable tweet about Jerome being gutless for not doing more etc, etc…but I suspect that he was rubbing his hands together with glee. All he has to do to indirectly influence monetary policy is create economic uncertainty…happy days.

Now the long and the short of what I wrote was that the 25 basis point rate cut wasn't justified, particularly given the near zero level of interest rates already. And I say ditto for our Reserve Bank, where I do think the local economy needs a boost but using up the last of their stimulus 'bullets' is futile and may prove to be a great folly if it doesn't work. Thus I think fiscal policy should be the main tool for fixing the world's (and our) economic woes.

And that brings me to the elephant in the room...U.S. China trade relations. This is the road block that has the world economy and it's financial markets stalled. (And certain spurious communications from Washington aren't helping) Low interest rates stimulate investment markets by providing cheap money and allowing yields to fall and stock & bond prices to rise. But they pale in comparison to the impact of the world's two largest economies not getting along. This means a massive reduction in world commerce and trade.

So what do I think the markets are going to do in the final quarter of 2019? And unfortunately I can't give an answer to this question until we at least get to the other side of the U.S. China trade talks, scheduled for Thursday next week. I see it in a pretty binary way...either the Trump administration wants a shot at winning the next election or it will take a fatalistic approach to dealing with China. I truly hope it's the former.