The last week’s market highlights:
Quote of the week:
“The difference between genius and stupidity is that genius has its limits.”
– Unknown (but widely attributed to Albert Einstein)
– Unknown (but widely attributed to Albert Einstein)
Each week, we present our featured topics in the context of the major themes listed below from Nuveen’s Midyear Outlook :
- U.S. economy: Late cycle but no recession
- Global economy: Still looking for a bottom
- Policy watch: Easy monetary policy to offset restrictive trade policy
- Fixed income: Volatile interest rates but no breakout in either direction
- Equities: Get defensive, stay invested
- Asset allocation: No longer “risk on,” but still prefer emerging-market bonds
Policy watch #1: The ECB delivers the gift that should keep on giving
With his eight-year term as European Central Bank (ECB) president expiring next month, Mario Draghi didn’t go out with a bang—but with a bazooka. At the ECB’s September 12 meeting, he announced an ambitious monetary easing program designed to jumpstart sluggish growth and persistently low inflation in the eurozone. The open-ended stimulus salvo includes plans to:
- Reduce the deposit rate from -0.4% to a new record low of -0.5%, with a pledge to keep it at that rate (or lower it) until the region’s inflation outlook improves. Rather than pay interest to commercial banks on their overnight deposits, the ECB will charge even more for holding their cash.
- Restart quantitative easing (QE) by buying €20 billion of bonds every month starting in November “for as long as necessary.” The ECB paused its asset-purchase program in December 2018.
- Ease borrowing terms for banks to promote business and consumer loans.
In addition, the ECB trimmed its inflation forecast by 0.1%, to 1.2% this year, and by 0.4% next year, to 1%. Both levels are well below its 2% target. The central bank also cut its growth outlook, to 1.1% and 1.2% for 2019 and 2020, respectively.
Despite these grim numbers, several ECB officials opposed reviving QE. One, for example, countered that QE should be unleashed only when the eurozone faces a high risk of deflation, which doesn’t exist now. Another feared that the ECB would be left without ammunition if the economy were to slip further. Yet a third didn’t think the growth outlook was weak enough to justify such an aggressive tactic.
In the immediate wake of the policy announcement, the euro retreated against the dollar, and German bond yields, which serve as a benchmark for the eurozone, fell deeper into negative territory. Both declines signaled that the market was underwhelmed by the ECB’s response.
But those drops were erased by the time the markets closed on September 12, as investors digested the ECB’s proposal. The euro rallied against the dollar and Germany’s 10-year bund yield edged up. Both rose the following day as well. European stocks also posted gains on September 12 and 13.
For his part, Draghi believes the ECB has done all it can. During his press conference, he underscored the limits of central bank stimulus. “Now is the time for fiscal policy to take charge,” he said.
Policy watch #2: The president’s got a bone to pick with the ECB and Fed
Markets may have been pleased with the ECB, but President Trump wasn’t. He quickly took to Twitter, reiterating his complaint that the ECB was attempting to “depreciate the euro,” thereby giving eurozone exporters an unfair price advantage. (A weaker currency makes goods less expensive in overseas markets.)
Earlier in the week, Trump vented at another familiar foe: the Federal Reserve. With the Fed’s September 18 meeting fast approaching and markets widely expecting just a 25-basis-point cut in the fed funds rate (to a range of 1.75%-2.0%), he called for Chair Jerome Powell and his colleagues to lower rates to “zero or less.”
We think the president should be careful what he wishes for. Dramatic rate reductions send a powerful signal: The economy’s in trouble. That’s clearly not the case with the U.S., though. The job market’s still chugging along, wages are rising and consumer balance sheets remain healthy.
Moreover, negative rates are accompanied by potentially nasty side effects. Consider the following:
- The Fed loses flexibility. With rates so low, the Fed would have little or no scope to ease policy to help fend off a recession.
- Savers will suffer. Remember the days of 0.25%—or lower—money market rates? They would certainly return.
- Confidence crumbles. Consumers may tighten their purse strings rather than spend, thereby restraining the U.S. economy’s primary growth engine. Banks could rein in credit instead of lend. And potential borrowers may assume that further interest-rate cuts are forthcoming, and thus wait for more favorable terms. Bottom line: The desired benefits of negative interest rates—greater spending, investment and borrowing—may not materialize if optimism declines sharply.
In addition, despite the president’s pleas, the Fed can’t pull the entire U.S. Treasury yield curve below zero. It’s true that shorter-dated U.S. government securities (i.e., those with maturities of two years or less) closely track Fed policy, so the Fed can “anchor” the short end of the curve. But yields on longer-maturity Treasuries, including that on the bellwether 10-year note, largely reflect market expectations for future economic growth and inflation.
Then there’s the issue of whether negative rates actually jump-start economic growth. Take the eurozone. Since the ECB instituted subzero rates in June 2014, the region has yet to reach 3% year-on-year quarterly GDP growth. In fact, GDP expansion hasn’t breached 1.7% for four straight quarters. Japan’s performance has been even worse. Since its central bank took the negative plunge in January 2016, the country has managed just two quarters of 2+% GDP growth.