It is a design fault amongst perhaps the majority of economists that, when things don’t quite go according to their forecasts, they will either ‘blame the data’ and stick to their previous view for too long, or attempt to finesse a ‘U-turn’ in such a way that it does not look like one so as not to undermine their short-term credibility….
Better economists admit that things change unexpectedly and that the world is a complex model of ‘simultaneous equations’ and dependent variables and that, when things change sooner than they expected, or in ways that they did not expect (i.e. they are simply wrong), then the optimal course of action is to change one’s view as quickly as possible (i.e. as soon as you are sure that things have changed). Keynes fell into the latter camp and hence we have borrowed his retort to some criticism or other that had been fired against him in the 1930s and we suspect that Chairman Powell may have fallen into his example.
The Financial Times and others may want to criticise Powell (as they have done today) for seemingly changing tack but we believe that he was entirely right to acknowledge prior mistakes and new data.
The prior mistake made by the Federal Reserve Board (Powell may or may not – and we suspect the latter – have been involved in the actual mechanics making the mistake but the is Chairman) was to overrule the analysis made by the Dudley-era New York Federal Reserve on the impact of QT.
We understand that the NY Fed was heavily defeated in the debate over QT when it argued that the FRB needed to be very careful when it began to shrink its balance sheet. The NY Fed had argued that there was in fact no such thing as excess reserves in the system, since a (small) number of relatively aggressive banks were in fact fully utilizing their supposed excess reserves as a liquidity buffer / pool of settlement cash in order to support a vast network of intra-financial system lending, much of it across exchange traded derivative markets. The NY Fed therefore argued correctly - but unsuccessfully at the time – that if the FRB reduced the level of excess reserves in the system it would cause a marked sea change in (global) credit conditions.
A year or so later, the relevant data shows quite unequivocally that the NY Fed’s analysis was indeed correct, and that the Washington-based FRB was wrong to overrule them. Powell may have buried the acknowledgement of this error in the ‘Implementation Statement’ part of his address yesterday but it is clear that the Washington Board now knows that it was wrong. The data has been, as we have been noting for months, quite unequivocal on this issue.
The second part of the acknowledgement process by Chairman Powell centred on the state of the world. We have described time and again how the ‘consensus’ of analysts are constrained when it comes to the world’s second-largest economy / largest importer of goods and services. China’s current system makes it simply illegal to disseminate what might be considered as representing ‘bad news’ on the economy. Hence, consensus estimates and the public forecasts from politicised institutions such as the IMF / World Bank have to perpetuate the fiction that China’s economy is currently growing at a seven percent rate (we doubt that growth is half that amount at present…) and that China’s industrial sector is expanding at a 5 – 6% rate, when in reality it is contracting at such a rate.
These are no small considerations or mere technicalities; the ‘error’ with regard to China’s GDP growth implies that global GDP growth rates in reality are likely to be half the number that the IMF publishes (i.e. closer to a recession than expansion) and the global IP data is likely to be ‘wrong’ by 300 b.p.! Brokers, or those wishing to sell newspapers in China simply cannot question this data, however nonsensical it may seem.
It is our very definite impression that the Washington Fed does not use these consensus numbers. Other parts of the government operate their own economic monitoring functions (a consequence of them having failed to spot the demise of the Russian economy in the late 1980s) and the Fed also makes use of genuine independent un-censored analysis. Consequently, the Board will have been aware of just how weak China’s economy has become. Similarly, we suspect that the BoJ, that makes heavy use of its corporate contacts will also have a fair idea of China’s true position at this time, unlike the ECB that apparently uses consensus sell-side forecasts and a perma-bull research provider for its China inputs. We suspect that if those criticising Powell were privy to what he was seeing, they would be much less critical of his decision yesterday. Certainly, when it comes to the state of the World economy, the Facts do Seem to be Changing – even relative to our previously very bearish outlook.
Below, we show some of our favoured world indicators and there does seem to be a rather consistent and quite frankly rather scary message emerging.
The charts above suggest that there is now a very high probability of a global recession occurring by mid-2019. Moreover, our China-data- adjusted estimate of global industrial production has global IP shrinking at 1.1% YoY rather than the +1.8% suggested by the conventional data, thereby signalling that the Global Industrial Sector is already in a recession. It should further be noted that much of the updated data that we show in the charts above has only been made available over the last 72 hours. When the Facts Change……
While we might criticize Powell for allowing the type of aggressive QT that has helped to bring the global economy to this position (he clearly is not to blame for China’s credit excesses and Europe’s structural problems), we would not criticise him for reacting to this new data in the way that he did yesterday.
Post the Fed Statement Has Anything Really Changed?
We had previously expected the FOMC to raise rates by 25-50 b.p. during the first half of 2019 and it now looks likely that the Fed Funds will probably stay unchanged or only increase 25 b.p. in the near term – as Powell remarked the US economy is continuing to expand and it is still overheated and, from a US-centric perspective, he could still feel justified in raising rates in the near term. However, we also believe that plus or minus 25 basis points on the Fed Funds rate is relatively immaterial in a world in which notional real USD rates have just moved from almost minus 10% in late 2017 to around 1% (or more likely 3-4%) positive in the space of 12 months. For more on ‘real rates’ see last week’s GLOB191 paper.
Much more significant were the Chairman’s statements on the outlook for QT. Over the next four weeks, the FRB will reduce its portfolio of securities by a further $50 billion (i.e. an unchanged rate) but we suspect that this action will be offset, in a monetary base sense, by a probable reduction in the US Treasury’s holdings of cash at the Federal Reserve (the “TGA”). In fact, given the confines of the Debt Ceiling rules, the US monetary base may increase by $50 billion between now and the end of February and this may create a slightly positive backdrop for risk markets (but not the external value of the USD), particularly in light of yesterday’s news.
Looking further ahead, there is now a greater likelihood that QT will not continue into 2019Q2 and if this is the case, then we can estimate that there should only be a $100 billion or so seasonal tightening in liquidity conditions over the quarter. This would be equivalent to ‘half’ the contraction that occurred in 2018Q2 – a contraction that proved so disruptive to markets at that time. However, the anticipated contraction in the monetary base in Q2 – even if QT is suspended – would still be of a similar magnitude to that which occurred in 2018Q4. Thereafter, we would expect a broadly neutral ‘quantity of base money’ environment for a few months. In short, we would expect base liquidity conditions to be quite positive for the remainder of the first quarter, less negative than they might have been in the second quarter and neutral in the third quarter. The fourth quarter might then witness a renewed seasonal squeeze on liquidity, other things being equal.
However, there are ‘other moving parts’ to the system. The FOMC may be becoming more dove-ish but it is not clear that the US, Japanese, UK and Australasian regulators are becoming more generous with regard to their oversight. Meanwhile, Europe’s banks are still struggling to raise capital and the BEAT changes are still in force when it comes to the tax treatment of borrowing USD onshore. In addition, the TechnoDollars are still being repatriated.
We also do not know if the (relatively few) major global lenders will respond in a positive way to the Fed’s announcement, or whether they will continue to tighten their own internal credit standards. We sense that they may continue to do the latter.
Therefore, just as occurred with some of the QEP era policies, a more expansionary / less restrictive central bank stance may not equate too much in the way of an economic stimulus. Ultimately, we will not know whether Powell has succeeded in boosting (we would shy away from suggesting ‘saving’) the Global Economy until we gain access to the data for bank wholesale funding and global capital movements in the weeks and months ahead. We would not wish to speculate too much at this stage on what this data will show but we suspect that the banks’ response to this week’s events may turn out to be quite disappointing. However, it will take some weeks before we can confirm this and until then markets will probably choose to ‘believe’ in the Powell-Put.
However, if it turns out that their faith in Powell’s ability to turn the credit cycle around is mis-placed, then at some point they will have to confront the rather inconvenient reality that not only is the Global economy (very) much weaker than they imagined but that the Fed has been impotent to change the situation…
Another important question is how will other central banks react to the Fed’s news? Truth be told, we suspect that the ECB will be able to do very little and even if it does do something the effects may be limited or even counter-productive. Since May 2015, the ECB’s balance sheet has expanded by EUR3.5 trillion (including TARGET2) but the EZ’s broad money supply has only expanded by EUR1.6 trillion and the volume of credit to the private sector (including to other fincos) that is outstanding has actually declined by EUR200 billion! Given that interest rates in the Region are already too low, we might suggest that the ECB is probably ‘played out’ and that its best hope is either that the EUR falls or the global economy around it improves.
The Bank of Japan has meanwhile tired of QE and it too knows that its economy would probably fare better if rates were higher, but it fears the impact that higher rates might have on the JPY at an awkward moment in the global cycle. The bigger question is, however, what the PBoC will do against the background of a less hawkish Fed.
Our guess is that the PBoC will err towards easing sooner (particularly in light of the data that we show above) and while this will presumably allow the PRC’s economy to stabilize in 2019H2, which could be of benefit to global growth trends in 2020, it will likely also bring forward a globally-deflationary decline in the external value of the RMB. As we noted earlier, Asian export prices have already entered deflationary territory and a weaker RMB would only add to this problem. Note, falling Korean export prices normally always signal an impending Global Deflation Scare.
In summary, the Federal Reserve has – entirely correctly in our view - reacted to the latest slew of economic data that suggests that, while the US economy itself may still have some momentum, the global economy is teetering on the edge of a potentially deflationary recession. Certainly, the data from both Asia and the EZ looks far from bright and actually quite worrisome.
However, for all of the hoopla and excitement over Powell’s apparent U-turn on rates and QT, the fact remains that the FOMC has not yet actually done anything ‘concrete’ and furthermore it is not clear that even if the Fed does suspend its QT – as we believe that it will in the second quarter – that this will be sufficient to revitalize the global credit cycle and hence global activity in the near term.
Arguably, the Fed’s actions will make it more likely that the PBoC will move to resuscitate the PRC economy in the near term but we continue to believe that, if the PBoC does act, the initial effect will be to cause a global deflation shock by undermining the value of the RMB.
It may well be that the excesses that were created during the 2017 Global Credit Boom have already been revealed and that it will take more than mere words and guidance from the Fed to address the global hangover that has already started. In the very near term we would be ‘long valuations’ but short ‘earnings’ and the USD but we suspect that the outlook for the middle and latter part of 2019 will be decided by just how the global financial system reacts to the Fed’s decisions this week. If their reactions are modest, the markets may have to contend with a Global Recession in 2019H2.