Seven years ago today, following frenzied weekend meetings, Lehman filed for bankruptcy. It confirmed the end of an era in a way that Bear Stearns demise had only hinted. The world has not been the same since.
The end of the secular credit cycle was a shock felt around the world, but it is the policy responses that shape the investment climate today. The aggressive fiscal and monetary stimulus by the US paved the path for an economic recovery earlier than most. Large US banks were forced to accept recapitalization funds. A new regulatory regime was launched to strengthen risk management, consumer protection and investor confidence.
Since the middle of 2009, when the financial crisis-induced economic contraction ended, the US has created 11.3 mln jobs. That includes the loss of about 500,000 government positions. The US economy is larger than ever before.
The budget deficit that peaked at over 10% of GDP is now less than 3%, with only mild austerity — many fiscal support measures were temporary, and rolled off, while others were counter-cyclical stabilizers, like unemployment compensation, that were less needed as growth returned. Tax revenues were also lifted by the return to growth.
The different policy responses to the crisis generated different economic outcomes, and it is this divergence that is the chief characteristic of the investment climate. The US may be ahead, but it has not returned to status quo ante. Partly, time has marched on. The demographic situation has continued to evolve. Baby Boomers are retiring. Partly, productivity, the deus ex machina, has slowed considerably. While these factors may account for the bulk of the slower growth, there still seems to be a cyclical, and possibly a cynical component (e.g. the sharp rise in disability claims).
The eurozone and Japan were considerably slower to respond. They did not offer an aggressive policy response until much after the US (and UK). While the US has largely cleaned up the banking system, for example, eurozone banks are still hobbled to some extent by the overhang of bad debt.
Japan’s story is a bit more nuanced. The election of Abe and the selection of Kuroda were key, but it was as if Japan lost its nerve when it lifted the VAT (at the encouragement of the IMF and rating agencies). It derailed the nascent recovery. It still has not returned to a strong growth path, even though Japanese corporations are showing strong profitability and the government is engaged in a multi-year corporate tax reduction. Tax consumers and cut taxes on corporations is not a particularly effective pro-growth strategy.
Many in the market still expect more asset purchases by the ECB and BOJ, and probably before the end of the year. The divergence meme is not really predicated on the precise timing of the Fed’s lift-off. The point here is that both blades of the scissors are moving. Many countries are still easing, and sooner or later the Fed will hike rates. Based on the current information set, the talk that has circulated for about a month now that the Fed will or ought to do another round of asset purchases seems far from the mark.
By the Fed’s own calculations, the unemployment rate is at levels that are considered full. There have only been a small number of times in the past quarter of a century that unemployment has been lower. US home owners have refinanced, locking in lower yields, in a way that is not possible in countries with less developed mortgage markets, including the UK. US economic growth has become somewhat more volatile and lower than in past cycles, but when allowances are made for the collapse of investment in the oil sector, Q2 US growth was the strongest in nearly a decade.
While Summers and others can make a compelling case for public investment, what is the case for another round of asset purchases? That the stock market fell more than 10% from its highs? That the decline in oil prices, and other industrial commodities slows the pace of the debasement of the dollar’s purchasing power?
How is it that many market participants feel more confident that the UK will raise rates, while they are skeptical about the Fed? Earlier today the UK reported that consumer prices are flat year-over-year. Like the US, the UK is experiencing a decline in goods prices (-2% year-over-year), while service prices are increasing (2.3% year-over-year).
The US data today was mostly disappointing. Headline August retail sales and industrial production (including manufacturing) missed expectations. The fact that the July series were revised higher may mitigate the impact on Q3 GDP. However, the data plays into fears that what is happening “over there,” the knock on effects of developments in China and the tightening of financial conditions, setback the US economy.
That would seem to play into ideas that the Fed will not hike rates this week. Yet, look at what has happened. US yields are higher; both the two-year and ten-year yields are 2-3 bp higher. One may be tempted to say that is a result of the stock market rally, but the September Fed funds futures imply a slightly higher yield and the dollar is stronger.
We suspect if the Fed does not hike rates this week, its statement will be rather hawkish, suggesting a rate hike has been delayed, but that it is still forthcoming. Parallels could be drawn between this and September 2013, when nearly everyone (not us) thought that the Fed could announce the tapering of QE3+. Instead it waited until December.
As Fed officials have noted, and we concur, raising the Fed funds target to 25-50 bp, given the current economic conditions cannot fairly be considered tight monetary policy. It would be wee bit less easy, but still highly accommodative on almost any reasonable metric. The 0-25 bp current Fed funds target was an emergency setting. If the economy was performing then as it is now, would the Fed have adopted the near-zero interest rate policy? Mostly likely not. Tight monetary policy is not warranted (as the QE4 camp argues), but nor is an emergency setting that denies officials the use of traditional monetary policy.
If the euro breaks $1.1260, which it has approached after the US data, it could move into a $1.1200-$1.1230 range. A break of the $1.1200 points to $1.1100-$1.1150. The greenback was sold to JPY119.40 in Tokyo, but it has recouped its losses now. Near-term potential extends toward JPY120.50. A close above there would be constructive from a technical point of view. Sterling cannot get out of its own way. Near $1.5350, it is at three-day lows. A break of $1.5330 could spur another cent decline.
The dollar-bloc is heavy. The Aussie has been turned back from its best level this month seen earlier today near $0.7165. Look for $0.7030-$0.7060. The US dollar is within yesterday’s range against the Canadian dollar. Despite the firmer oil prices, the Canadian dollar cannot make any headway.