It has been an erratic three months for equity markets. The S&P was Goldilocks in April (+3.9%), but lost it all and then some in May (-6.8%) due to Trump’s tariff tweets. There was a strong rebound in June (+7.2%) on the expectation of Fed easing, and a record high in the first week of July on a renewed trade truce. Notwithstanding the damage already done to capex plans, supply chains, and global manufacturing by the existing trade tariffs and uncertainty, the equity market is signalling strong growth ahead. This is, admittedly, partly the result of expectations for Fed rate cuts and attendant sharp fall in bond yields, which have eased US and global financial conditions.
The slump in developed market bond yields is telling a different story – it signals concern about growth, evident in lower real yields, as well as deflation fears. The debate centres on whether pending Fed cuts are in reaction to a recession that has already begun – in keeping with yield curve inversion – or whether the FOMC will opt for insurance cuts to extend the already long expansion – in so doing vindicating the buoyant equity market.
The 1H19 repricing in monetary policy expectations has triggered a scramble by some analysts to revise their forecasts. While few are projecting a US recession, some expect insurance cuts to offset the impact from trade wars and the waning impact of prior fiscal stimulus. The Fed Funds futures market is fully pricing in a rate cut at the July FOMC meeting, but the latest Bloomberg consensus analyst poll shows that 68% of the contributors expect the Fed to remain on hold. Granted, we do not know with what conviction these views still hold, but the trade truce and rebound in US employment numbers in June should have lowered the probability of imminent Fed easing.
It is not obvious that the Fed should be cutting rates based on above-trend real GDP growth, the resilience in the equity market, and the high profit-share in the economy. The primary arguments for cyclical easing are the inflation misses in recent quarters and the slump in market-based inflation expectations. Yet, if inflation dynamics have changed with a weaker impact from slack – the output gap, labour market, and wages – towards other factors such as global integration, demographics, and technology, then it seems bizarre to expect lower interest rates to drive consumer price inflation higher. If anything, the fear of asset price disinflation, specifically an equity market sell-off, is driving Fed expectations. That and the risk of a Trump Twitter tirade that Powell is not doing what he should be.
Another perversion is that the dovish wave has swept over other global central banks, with the ECB, in particular, making a shift with Draghi’s “whatever it takes 2.0” and Lagarde’s nomination as ECB president. As a result, relative policy expectations have kept a floor under the dollar, and a strong dollar will offset the inflationary pressures from services and tariffs to some extent.
If the Fed does decide to pause this month, it will have to explain it very carefully to prevent a sharp sell-off in rates and risk assets.
The Fed’s revised stance has given EM central banks room to manoeuvre thanks to the recovery in EM FX and widening yield differentials. The SA market reflects this, with the FRA curve fully priced for a 25bp rate cut in July. Yet, we cannot ignore the political pressure on the SARB based on the ANC NEC Lekgotla Statement referring to the SARB mandate and “quantity easing” and recent Treasury official quotes that the level of interest rates is the issue rather than the mandate. The Treasury and the SARB have subsequently released a joint statement emphasising the SARB’s independence, but the cat is already out of the bag.
The fiercely independent MPC may now dig in its heels against rate cuts due to mounting risks to the sovereign credit rating, government funding, and political interference. Alternatively, the MPC was coming round to the idea of rate cuts all along and easing now would look as if the SARB were bowing to political pressure. SA is certainly a more obvious candidate for substantial central bank easing, even if monetary policy should not bear the blame for the substantial deterioration in growth over the past five years.
There is much disagreement about the appropriate level of interest rates, but the perspective is important. Borrowers will bemoan that borrowing costs are too high, while savers will complain that they are too low. Given SA’s saving/investment imbalance – evident in the current account deficit and reliance on foreign portfolio inflows – the level of SA rates relative to the rest of the world also matters. A wider interest rate differential assists to buttress the currency in the short term, while low stable inflation helps to steady the real rand in the long-term.
Within the SARB MPC, there are similar disagreements. With only five MPC members contributing to the July meeting, the divisions within the committee make the repo rate outcome a much closer call than what the market is reflecting. Outgoing Deputy Governor Mminele has effectively been replaced by Dr Chris Loewald, leaving the compositional bias of the MPC on the hawkish side. Yet analysts have rapidly swung in favour of a July cut, in large part due to the underappreciation of the extent of the Q1 GDP contraction. This could also be enough to pull the neutral MPC members over the cutting line. If the SARB decides to stay on hold, then the next opportunity to ease will be in September. But this is ahead of the crucial Medium Term Budget Policy Statement in October and, based on the past two years, the event has not been good for SA FX and rates. Hence, from a risk management perspective, the hawks may remain reluctant to cut at all.
A lower global neutral policy rate assumption – in line with the fall in the Fed’s dot plot – and a wider output gap could lead to the SARB’s main econometric model – the QPM – to price in two rate cuts versus only one at the May meeting. Yet a more substantial change would come from a recalibration of the neutral real SA rate assumption to better align it with the sustained lower potential growth. This is sort of what happened in Chile where the central bank did an about-turn in June by cutting rates by 50bp after hiking by 25bp in October 2018 and January 2019, respectively. This was touted as a recalibration cut due to revised parameters in the central bank’s model. If SA were to update its QPM assumptions in line with the lower global r-star, then there would probably be scope for more substantial easing.
As we have seen over the past two years, reluctant repo rate cuts have had a limited impact on growth and have even been partially reversed, again by a close MPC vote. Surely, a series of measured cuts would arguably do more good to ease financial conditions and lift business and consumer confidence than a one-and-done.