Market Commentary – February 2020
By Neil Worsley, Investment Strategist
Recent meetings of the UK’s MPC and the US Federal Reserve saw both committees decide to hold interest rates unchanged, for the time being at least. These decisions were made in the face of relatively sluggish economic growth and at a time of heightened uncertainty caused by the spreading Coronavirus. While many countries have interest rates that are lower than the United States (Japan, Germany, Switzerland, Denmark, France, Spain, and Sweden, to name a few), is President Trump correct that rates in the US (and the UK) should also be brought down in order to remain competitive?
Although many countries have a lower cost of funding than the UK/US, the monetary policy that moved their yields to such low levels, did not design this as a proactive strategy. Instead, negative rates are the outcome of an economy that is in deep trouble. What does it say about an economy if it can't entice investment with a zero cost of capital?
According to President Trump’s logic, a country like Japan, a country that has had meagre short and long term interest rates for more than a decade, should be crushing the United States economically. That has not happened. The cumulative nominal GDP growth in Japan for the last ten years is negative 5% compared to positive 42% in the US. If the level of interest rates and, by extension the currency, was the only factor in determining competitiveness and economic growth, you might expect those numbers to be reversed.
It's worth mentioning that central banks have limited control over long-term interest rates, although the advent of quantitative easing is changing that in some parts of the world. Long-term rates are set by the market, with the level determined by a combination of the inflation outlook, supply and demand and market technicals. The Fed does NOT control the yield on the long bond.
Fortunately for those concerned about the economy, long-term yields in the US have already fallen, with the benefit to the economy starting to accrue to rate-sensitive sectors such as housing.
30-Year Government bond yield.
It’s also worth remembering that a move back to low or even negative short-term rates in the US would be very punitive to the financial sector and banks that extend credit to consumers. Margins would get slashed and the costs would eventually be passed on to depositors.
Whether monetary policy in the US is too tight or not, one thing is clear, the rest of the world is in easing mode. So even if official policy rates are appropriate for the US in absolute terms, they appear relatively tight to other central banks that are loosening policy to combat deflation and their weak economies. The outcome of a relatively tight policy is a strong dollar. A strong dollar hurts exporters and provides a headwind to President Trump's goal of reducing the trade deficit. Maybe that is what he is referring to when he says the "Federal Reserve does not allow us to do what we must do."
The President is right about monetary policy if the goal is to weaken the currency. He is not right to compare US yields to those in Germany if the Fed is to follow its mandate bestowed on it by Congress to "promote effectively the goals of maximum employment, stable prices, and moderate long term interest rates."
The Fed may possibly lower interest rates again in the coming months, but it should do so in response to falling inflation expectations and a weakening economy. It should not lower rates to weaken the US dollar to try to balance the trade deficit.
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