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Europe is where the rubber hits the road
One narrative that isn’t getting enough press is the one that sees the December Fed rate hike as a policy error. And I want to go into this through a sort of catch-all post about slowing global growth and the associated policy response by starting out in Europe. I see Europe as a weak link, both in terms of growth and its institutional architecture to deal with slowdowns.
The framing here is that euro area countries are uniquely vulnerable due to the lack of policy space from not having a sovereign national currency. That means euro countries cannot reflate via fiscal policy. To a degree, they can rely on monetary stimulus. But the ECB has just ended QE. So, mostly, they have had to resort to the internal devaluation of wages and prices to ‘steal’ growth from abroad via an improving external account.
Now that global growth is slowing, the euro area is in trouble. The EU has just reduced its growth outlook to 1.3% this year from their previous forecast of 1.9%. That’s what I would consider stall speed, meaning vulnerable to recession from economic shocks.
The key here is that the ECB, like all major central banks, is keen to normalize policy. That’s why it has ended QE. And it will only loosen policy under duress. Is the ECB being too tight? Quite possibly. Remember that just last week the EU’s statistics agency Eurostat said the year-on-year increase in prices had fallen to 1.4% in January, from 1.6% in December. That means inflation is further below the European Central Bank’s goal of 2%. So, not only is growth slowing, but inflation is falling too.
And notice that the European Commission has cut Italy’s growth forecast to a five-year low – blaming the cut in part on the populist government’s attempts to flout the stability and growth pact.
Meanwhile in the UK…
Brexit is the big issue for Britain. And the Bank of England announced yesterday that the UK faces its weakest economic growth in a decade as it prepares to leave the EU amid a slowing global economy. So, the UK is in the same boat as everyone else on this score. The BoE cut its 2019 growth forecast to 1.2% from November’s forecast of 1.7%.
That’s actually the biggest forecast cut since immediately following the 2016 Brexit referendum. And while I told you in 2016 that the forecast cut was “motivated reasoning” – which proved true – I am less sanguine here. I do think the BoE is right to cut forecast, even if only due to slowing global growth.
But, notice that the Bank of England had wanted to normalize too. When the BoE announced its policy guidance and forecast yesterday, the FT headlined “Bank of England pulls back on multiple rate rise plans“. So the BoE is only leaving rates unchanged under duress – just like the ECB. It wants to normalize. But it can’t because the data are so weak.
As for Brexit, you know my view: a no-deal Brexit remains the default option, but is so unpalatable to all sides in a slowing global economy that it is likely we see a delay in the Brexit timetable. Theresa May is basically trying to blackmail everyone by leaving a no-deal option on the table to create leverage with the EU and within her own party. But, she is having no success in getting the EU to open up the Brexit deal for renegotiation.
The worst case scenario is that the UK crashes out on March 29. And, in that case, the disruption will be large. Outside of the UK, Germany and Ireland will feel massive economic pain. It could mean a recession for the eurozone. More likely, there will be some sort of delay. But, we need to get beyond May’s stalling to understand what the legitimate options are.
And in the US…
The outlook has been significantly better for Americans, with, until recently, no hint that recession was a consideration in the near term. That allowed the Fed to not just raise interest rates, but to accelerate its timetable in 2018 from three to four rate hikes. Even after the market’s wobble in October, the Fed stuck to its guns and raised rates a fourth time in December.
Was this a mistake, though? St. Louis Fed President Jim Bullard, who a non-voting FOMC member at the time, is suggesting it was. Look at the presentation he made yesterday (link here). His synopsis:
Three themes for 2019
- The Federal Open Market Committee (FOMC) may miss its inflation target on the low side for the eighth consecutive year in 2019based on current readings of market-based inflation expectations.
- The U.S. labor market is performing well, but feedback from labor markets to inflation is very weak.
- The Treasury yield curve has flattened significantly, and a meaningful and sustained yield curve inversion would send a bearish signal for the U.S. economy.
Translation: The Fed shouldn’t have raised rates in December. His whole presentation is saying that inflation expectations are too low for the Fed to be on a rate hike train at all. And he’s concerned about yield curve inversion and recession. I think this is fundamental reading because I think the whole FOMC is quickly moving toward the Bullard view.
So, while the US growth prospects remain better than elsewhere, the concern has rapidly moved from upside risk and overheating to downside risk and recession.
Policy and market implications
Let me start this with a shout-out to SocGen strategist Albert Edwards. On the back of a San Francisco Fed piece, he predicted the US would be forced to move to a negative interest rate policy (NIRP) regime when the next downturn hits. And I thought he was onto something.
The Fed has a very limited arsenal right now, frankly. And it has paused already. It may be done. When the next downturn hits, what does it do then? Yes, some Democrats are talking up deficit spending. But it’s clear to me that Nancy Pelosi won’t green-light any of these proposals in the house. And the Republicans aren’t going to go for it either. Fiscal is done – at least until and unless things get considerably worse.
The Fed will basically be the only game in town. So, whether it buys short-term municipal debt, goes to negative interest rates, or what have you, I think it will be super-aggressive – shock and awe to overcome the (correct) belief its arsenal is depleted.
The ECB may get there first though. In the markets, people are already saying the ECB will be forced to reignite QE by March. That’s the word on the street. And it has people buying long-dated periphery government bonds. Two days ago, the Italians auctioned 8 billion euros of 30-year bonds at 3.85%. And there was record demand – 41 billion euros of orders.
Except for Greece, that’s the highest sovereign yield you can get in the eurozone – and the longest duration and most risk too. Clearly, someone thinks the ECB will have Italy’s back. But, will it? I have my doubts.
My take
Personally, I have grown a bit alarmed at the macro data coming out of the US. They are weak numbers. And my bullishness on US growth prospects have waned accordingly. While the belly of the US Treasury curve remains partially inverted, the 2-10 year differential is still at a manageable level, given there are no more rate cuts in the offing just yet.
I think the Fed still wants to normalize. And is pausing under duress just like the ECB and the BoE. In that sense, they are still too tight. But, to the degree the incoming data confirm the Bullard view on inflation and inflation expectations, we could see the Fed become much more dovish.
Notice that I haven’t mentioned asset prices at all in talking about the Fed’s policy stance. Money managers are incredibly self-absorbed in thinking the Fed’s policy reversal is mostly in response to asset markets. It’s not. There is a real and rising threat to global growth, including in the US. And the Fed has belatedly acknowledged this threat. The BoE have done too.
The ECB is the odd man out here. They continue to be too tight relative to economic conditions. And given that Euroland is the weakest link in the advanced world, at this point, I would look there first for signs of turbulence.