Back to the Future… Have we been here before?
ref: - "Rates Traders May Be Thinking of a 1998-Style Fed Rate Reduction”, Bloomberg Business
For all the recent ebullience in US equities, if there's one thing the economic commentaries are not short of its doom-mongers. Well, it's not as though there aren't plenty of reasons to take a dark view of the economic future should one be so inclined, and more disappointing data from Germany yesterday only confirmed the fact that the Eurozone, in particular, faces a real struggle to recapture the path to solid economic growth.
Europe is by no means alone but sometimes one has to look past the worried faces and remind oneself of exactly where we are right now. Anyone doing that might notice that the Chinese Slowdown story that undermined global growth expectations might not be as severe as originally thought. More to the point, what no one could deny is that in the biggest economy of all, the United States, things are still purring along pretty nicely. Markets may have been given a huge boost to recover all the losses of late last year and to regain new record-high ground by the halt to the Fed's rate tightening cycle, but the evidence of underlying strength is still strong too. Against quite a few expectations, the latest corporate earnings season is suggesting that the real economy is still robust, and it's not just a case of over-excitable stock market prices.
So why then, if things in the States are still going so well, are futures markets suggesting that the US Federal Reserve will cut rates by a quarter point this year? There are a few answers to that, not counting the slightly mischievous suggestion that they might do so just because Donald Trump tells them to. One might be that futures markets are just plain wrong, of course. Another one is that the Fed might have to cut rates as a pre-emptive move to counter headwinds from elsewhere... in other words, it would be a preventative move to protect and maintain the strength the US economy rather than a reaction to evidence of a domestic slowdown.
If that should happen, it would mirror events of 1998 when the Fed lowered rates to protect the economy from slipping into recession as a result of problems overseas… and they were pretty serious problems, too. The Fed had to consider both the Asian financial crisis and Russia's debt default. If you throw in the collapse of Long-Term Capital Management at home too, you can see the appeal of pre-emptive action. Today's Fed will be looking at Europe and a Japan still stuck in a deflationary rut rather than those problems of 20 years ago or so, but may come to the same conclusion about how best safeguard US growth. After all, it worked back then in similar conditions of a strong domestic economy (after a long period of expansion), low inflation and record or near-record stock prices.
One could always say the same thing of course, but it seems particularly true right now that all three possibilities for US rates in 2019 are still on the cards -- a hike, stay where they are, or a cut. If it's the latter, protection against those global headwinds may play a big part in the decision. But it's worth remembering that with rates currently at 2.25% - 2.50%, the Fed has a lot less room to play with that was the case in 1998 when rates were at 5.50%. And besides, it's hard to get away from the view that the inflation rate, both current and expected, will be the biggest factor in the Fed's thinking.
Stubbornly low inflation may be the thing that forces the Fed to cut. But then again, the old rulebook about inflation has been thrown out and these days nobody seems very certain about how it works. Many economists are still convinced that the US' tight labour markets and sustained wage growth must -- simply must -- push inflation higher sooner or later. The Fed may be thinking about tolerating a shortish spell of inflation above its 2% target to make up for the long periods of below-target readings but that surely wouldn't last long.
Like we say, all scenarios are still possible…