Feature Stories | Oct 16 2019
Saxo Bank suggests the failure of a decade of monetary policy experimentation will lead the world into recession despite the lowest rates in history. It will begin with US dollar intervention.
-Despite historically low rates, the global slowdown continues
-Demand for US dollars unabated, as liquidity runs dry
-A slow-moving Fed may be usurped by an angry Administration
By Greg Peel
"When history is written, suggests Saxo Bank in its December quarter global outlook, "2019 will most likely be remembered as the beginning of the end of the biggest monetary policy experiment ever – the year that kicked off a global recession despite the lowest ever nominal and real interest rates in history".
The GFC forced global central banks into the "experiments" of quantitative easing and negative cash rates. Ten years later, the US Federal Reserve is reintroducing QE and central banks elsewhere are lowering cash rates further into the negative in order to avoid another global recession. The Fed is arguing the billions it has pledged to buy short-term Treasury bills through to at least January is not QE – QE is the purchase of longer term Treasury bonds – but critics consider the argument semantical.
The major reason monetary policy does not work over a full economic cycle is that classic easy money policy works only in "normal times," Saxo suggests. When rates become too high or too low the model breaks down.
For example, Argentina's cash rate is 80%, which should result in massive capital inflows into the country. Germany's cash rate is now deeply negative, so money should thus be fleeing the country. But rather, capital is fleeing Argentina and being hoarded in Germany.
If monetary policy is failing then fiscal policy needs to step up to save the day. And at historically low interest rates, the opportunity for cheap government funding has never been greater. But the problem is, everyone is already up to the eyeballs in debt.
With monetary policy failing, and fiscal policy response following a long and difficult path, there is only one other tool left in the box for the global economy, suggest Saxo. And that is to lower the price of global money itself.
The Reserve Currency
There is an estimated US$240trn of debt in the world, or 240% of global GDP. Far too much of this debt is denominated in US dollars, says Saxo, due to the dollar's role as reserve currency and the deep liquidity of US capital markets.
Hence, movement in the value of all asset classes become a function of US dollar liquidity and direction. Too high a dollar not only impacts on US export competitiveness but on emerging markets with a high dependency on US dollar funding. A stronger greenback will thus weigh on global growth and create de facto disinflation, Saxo warns, despite central bank efforts to lower policy rates.
Financial markets value the US dollar against a weighted basket of the currencies of America's major trading partners, known as the US dollar index or DXY. The Fed has a broader version on the same trade-weighted basis that it uses as its own US dollar valuation. That is currently above 130, its highest ever level, and some 30% above the prior peak as recently as 2013.
Thus thundering into the mix comes President Trump and his persistent attempts to bully the Fed into lowering rates and thus ease the dollar. If Trump finally does lose patience with Fed chair Jerome Powell, the White House can enact powers to intervene and sell US dollars. The Treasury keeps US$95bn aside should ever this need arise. Notwithstanding the Fed could simply "print" money.
The US government has only intervened in currency markets three times since 1995; 1998 (Asian currency crisis), 2000 (dotcom bust) and 2011 (European crisis). Interestingly, were Trump to order such intervention he would not meet resistance from the Democrats. Leading contender for Democratic presidential nominee, Elizabeth Warren, has also called for a weaker dollar.
But a weaker US dollar can only buy time, warns Saxo. It won't offer a structural solution.
Equity Market Impact
Only this year did the Australian stock market return to the high mark set before the GFC a decade ago. In the meantime the US stock market has grown threefold. A major drag on the Australian market in the ensuing period was the crippling strength of the Australian dollar on the country's export economy. Only once the Aussie fell back to more average levels did the stock market respond.
America's is a domestic consumption-based economy. Thus while a strong US dollar impacts on export sectors, it does not impact on the US economy as a whole. Indeed, whenever the US dollar strengthens, the US equity market outperforms the rest of the world.
And vice versa.
US equities are currently expensive in both relative and absolute terms, Saxo claims, due to multiple factors including a higher level of share buybacks, safe haven status, higher profit growth driven by technology monopolies and a repaired financial sector. While valuations can remain elevated for some time, rich valuation premiums to other equity markets are typically not a good starting point for superior relative returns in the future.
In February this year, equity markets celebrated the tenth anniversary of the GFC market bottom, at which point equities had outperformed aggregate US government bonds by 336% or 16% per annum, Saxo notes. It's the best ten-year performance for US equities relative to bonds since 1973 other than the peak of the dotcom bubble.
It is quite likely the next ten years will not see the same level of outperformance.
The Liquidity Issue
Despite the -25 basis point cuts to the Fed funds rate in both July and September, with possibly another to come in 2019, liquidity in the US banking system had become so stretched the central bank was forced to launch a large overnight repo operation (feed funds into the bank overnight cash market) a day ahead of the September FOMC meeting.
This, says Saxo, suggested a major crack in the Fed's credibility and effectively tips the market off that the Fed is losing control of its balance sheet. Subsequently, the Fed has stepped up its operations, pledging to purchase short term Treasury bills beginning with US$60bn in October, with further purchases each month through to January.
The main force driving US dollar liquidity problems, Saxo claims, is mounting difficulty the US is having in funding its current account deficit, which is driven by the twin trade and "Trump" (budget) deficits, the latter having ballooned to -US$1trn a year pace of growth since the tax cuts.
As foreign central banks have lost their ability to accumulate more US dollar reserves, the funding for the twin deficits has largely shifted to domestic sources. But the balance sheets of US banks and humble US savers can't absorb the torrent of government bond issuance. Something will have to give, suggests Saxo, and like it or not it will have to be the Fed. So far the Fed has been too cautious to get ahead of the problem, but it is likely the December quarter will see the necessity to provide ever larger amounts of liquidity.
Or Trump may wrest control of policy.
"A heel-dragging Fed and dark clouds gathering over the economic outlook almost ensures that the Trump administration will be scrambling for the funding it needs to ensure Trump's re-election in 2020," says Saxo.
Having spent so long fearing entrenched deflation, the world may now be set on a path to the return of inflation, the analysts warn, probably stagflation (rising inflation and falling GDP).
One of the main problems is the agreement reached in August to suspend the US "debt ceiling" for two years. As a result, the US Treasury plans on borrowing an additional US$443bn over a three-month period, compared to the US$40bn borrowed in the prior quarter, thus ensuring major consequences for US dollar liquidity.
Currently the dollar shortage stands at -US$445bn, Saxo notes, and may reach an annualised peak of between -US$800-900bn in coming months.
Lower and Slower
Massive US Treasury issuance in a period in which there is already high US dollar demand will drain liquidity out of the market and further tighten financial conditions through October-November, increasing risks to market segments that are already fragile. But the view is more positive going into 2020, Saxo suggests.
Central banks will likely "go big" in coming months to cope with a global trade recession, trade war friction and a global slowdown. To date the Bank of Japan has provided the highest level of liquidity injection but other central banks will follow as financial conditions push the Fed into a dovish corner, Saxo believes, while the European Central Bank will need to support the eurozone economy for a prolonged period.
The US economy has continued to outperform the rest of the world on resilient US consumer demand and a still-expanding US services sector. The Fed has now cut rates twice but still has the highest cash rate by far in the developed world while all about have been relentlessly cutting.
Trump's trade war is causing more pain to the rest of the world than it is to the US, thus reinforcing US outperformance, and helping to strengthen the US dollar, not weaken it.
The case for ongoing asset flows into the US thus remains strong, Saxo notes, which is US dollar positive. For the US dollar to structurally weaken, other currencies must structurally strengthen.
Lower interest rates have kept equity market valuations high up to now given future earnings forecasts are discounted at a lower rate. But this mathematical equation ignores the reasons why rates are low in the first place. As the economic cycle slows and growth momentum wanes, the effect on valuations from lower rates is countered by falling profits and margin degradation, Saxo warns. So there comes a point where lower yields no longer translate to higher multiples.
To that end, equity investors need to become more discriminating in their stock selections, focusing on companies with strong balance sheets and resilient earnings duration and growth.
Sticking with defensive positioning across bond proxies with consistent and growing low-risk earnings streams, minimum volatility and quality factor exposures remains justified (despite market re-rating to date) — a position Saxo has maintained since the bank's March quarter outlook.
We recall that it was a massive injection of fiscal stimulus from China that helped pull the world out of the GFC a decade ago irrespective of monetary policy action from the Fed. China is again trying to stimulate its slowing economy but this time stimulus is more specifically targeted and hampered by transmission problems, Saxo suggests (you can lead a horse to water). China will thus not be the saviour this time around.
And there's not much central bankers can do about a trade war. A prolonged war means growth will remain subdued for a prolonged period, making US recession a very real risk.
Without a game-changer such as the end of the war, a weaker US dollar or a coordinated fiscal stimulus package across the globe there is little impetus to retreat from a defensive stance despite the occasional bounce in sentiment. To date fiscal stimulus has been touted all about the place, but without conviction.
"Australia is the poster child of this dynamic, Saxo suggests, "whereby the tax cuts already implemented have done little to spur consumer spending or confidence. The propensity to spend extra cash has been reduced as Australian consumers remain over-leveraged and devoid of any pick-up in wage growth while economic uncertainty is on the rise.
"More substantial fiscal stimulus will be needed as monetary stimulus loses its potency in order to boost productivity and reignite the private sector."
Yesterday Prime Minister Scott Morrison declared his budget surplus plan will not be "spooked" by international events, as the International Monetary Fund slashed Australia's economic growth forecast to just 1.7% and advised world governments to unleash fiscal stimulus.
Meanwhile, the US and China may sign "phase one" of the "deal" struck last week but progress on the sticking points of intellectual property and technology transfer remains allusive, suggesting despite any pops in sentiment along the way, pressure on risk assets lingers.
A subject that has not been raised recently is the one overruling sticking point that led to China pulling out of every trade negotiation through to April, and thus to Trump upping the tariff ante each time. Beijing says it will agree to Washington's demands if the tariffs are immediately lifted, while Washington has said it will lift the tariffs only when there is clear evidence Beijing is complying with the deal, given its previous track record.
How can this be overcome?
As the trade war rolls on, the risk is of a bleed of recessionary dynamics in the US manufacturing and industrial sector into services, jobs and the consumer, with monetary policy providing less of a cushion than previous cycles. Private consumption continues to underpin US economic expansion.
"At present, notes Saxo, "the Fed has been clear in its intention to extend economic expansion. But they have leant against dovish market pricing in their rhetoric and remain behind the curve. This is a problem, because as trade uncertainty looms and the economy continues to deteriorate, neutral rates will also track lower, meaning the Fed will have to move aggressively in order to provide relief and ward off a sharper slowdown.
"Without being well and truly ahead of the curve, the Fed will also not be able to engender dollar weakness: which will continue to be a significant hindrance to any reflation".
Simple mathematics has the price of gold rising as the US dollar is falling but this only works in US dollar terms. A falling US dollar would suggest a rising Aussie dollar which would cancel out the benefits of a rising US dollar gold price.
But the gold price does not just rise on a falling dollar. It is also considered a hedge against inflation and a safe haven in the case of geopolitical risk. The US dollar gold price can easily rise in the face of a rising US dollar.
Saxo believes gold (and precious metals in general) are set to benefit further in coming months given numerous tailwinds.
The Fed is likely to continue to cut rates, while embarking on another round of QE. One of the downsides to gold as an investment is it does not pay a return, such as a dividend or coupon. But with real bond yields expected to remain low across the globe, and negative in some places, the "opportunity cost" of holding a zero interest paying asset is no longer an issue, particularly where zero is better than negative.
Saxo sees further gold purchases by central banks looking to diversify and, for some, reduce dependency on the US dollar. The US-China trade war and geopolitical risks in the Middle East support gold's safe haven status. And as the dollar continues to climb in value, there is an emerging risk of US action to weaken it.
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