Interest rate divergence

The ECB is the first major central bank to cut interest rates cutting by a quarter of a percent. The widely-expected move will see the interest rate on its main refinancing operations fall from 4.5% to 4.25%. The rate on its marginal lending now stands at 4.5%, while its deposit facility interest rate is 3.75%.

The interest cutting decision on both sides of the Atlantic is laced with further economic complexities. The ECB are facing a familiar dilemma: they lower interest rates because inflation is slowing down and the euro will inevitably weaken. A weaker currency will increase the price of imports and this in turn may delay the fall in inflation towards their 2% target. The ECB is not the only central bank facing “external“ pressures. In the United States, there are serious concerns about the sustainability of the US national debt. The rising risks are the servicing costs associated with those debts. The most striking statistic for us is that the US is currently spending more on debt servicing than it does on defense. Why does this matter? There is growing pressure on the US FED to cut rates and reduce the debt burden associated with servicing these debt financing costs. We also must factor in the implications of the US Presidential election in November this year. If the FED commences rate cuts too close to the election they will be accused of supporting Biden. If they desist from cuts, will the Biden camp cry foul play? Whilst the Federal reserve is independent and should act objectively, it is naive in the extreme to think it is not political. The path to interest rate cuts has many dimensions across currency valuations, trade, politics, and market speculation.

Something strange is going on…..

Can I share some figures with you….

1. Total US treasury DEBT outstanding: ? ? ? ? ? ? ? ? ? $34.5 trillion
2. Amount debt is rising by every 100 days ? ? ? ? ? ? $1 trillion
3. Total Federal Debt-to-GDP: ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? 124.25% (Highest since WWII)
4. US Deficit: ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ?-5.75%
5. Budget Deficit (as of April 2024): ? ? ? ? ? ? ? ? ? ? ? ? ?$1.6 trillion

According to Jim Bianco the budget deficit in the United States is larger now than at any other period except the Great Financial Recession and Covid-19. Think about that for a minute. I thought the US economy is in an expansionary growth phase? Why then is it borrowing 25% of its spending and how sustainable is that? I am thinking about the FITCH downgrade almost a year ago and those pesky bond market vigilantes may have to put some order on this situation. This has implications for all assets! The chart above shows the deficit as a % of GDP over the last 200 years. The current level of deficit was previously associated with the Civil War, WWI, The Great Depression, WWII, the 2008 Financial Crisis and Covid-19.

What goes down must go up!

To understand the likely trajectory of future market interest rates, we could do worse than study financial history. Mark Twain famously noted that “history doesnt repeat, but it rhymes”. From an interest rate perspective this quote means that whilst it is unlikely that we will witness a complete replica of the past, there are some structural economic relationships that cause interest rate movements to rhyme or repeat. The most prominent of these structural forces has been the headline grabber in recent years - Inflation. Remember in the past, interest rates did not just decline in a vacuum of economic space. Interest rates declined because inflation fell consistently over time. It may be useful to ponder “why” prices fell in contemplation of why they may well run structurally higher over the coming decades. Before analyzing the disinflationary (falling inflation) trend between 1981 and 2011, it is important to assess what type of economic environment existed to drive interest rates in the US above 20%.

Bonds: Caveat Emptor

The consensus appears to be that Bonds are a “sure thing” and therefore we feel a need to balance the arguments slightly. The key question for investors today is what type of economic regime will future bonds exist in. If its an environment characterized by persistent inflationary pressures then the path for bond investors may not be a smooth one. The bottom line for us is that active management is key with your fixed income allocation as active managers can be selective with regards to their credit, duration and interest rate exposures. Famed bond investor Bill Gross recently declared that “total return” bond investing was dead…A big statement and difficult to ignore in the context of the “new normal” inflation and rate environment. Are there opportunities with bonds given their (relatively) higher starting yields - absolutely. Does it represent the same opportunity at the beginning of the 1980s disinflationary trend - absolutely not!

The “Godot” recession

Waiting for Godot is a play by Irish playwright Samuel Beckett in which two characters, Vladimir and Estragon, engage in a ?variety of discussions and encounters while awaiting the titular Godot, who never arrives

Another question that routinely comes up in client meetings is: Where is this recession?

Some commentators have labelled it the Godot recession owing to its delayed arrival despite mass predictions from the great and the good of the economics club. Many famous faces have had to admit defeat recently determining that they got it wrong. We have some sympathy for these mistakes given that this economic cycle has been unique given the Covid-19 influence. The playbook was pretty predictable in the past. Central banks increased rates to pull demand out of the economy and this usually slowed activity with a lag period. The average lag period (according to BCA) between the first rate hike and recession in the US is 29 months. The first rate hike in the US was 28 months ago so are we going to see a recession in the US? Perhaps! Last week (May’2024) there was evidence of deterioration with a slowdown in construction spending and a weak ISM manufacturing PMI data release. ?To address the question of “why” there has not been a recession yet, we can point to the preponderance of fixed rate mortgages in the United States which insulated home owners from steeper borrowing costs. Also, at the corporate level, many companies locked in low funding costs (when rates were very low) and did not have to refinance at higher interest rates. There are upcoming maturity walls (dates where corporates must refinance their existing debts) and this will increase pressures. A third reason for the resilience of the US economy has been the “rolling recession” thesis which argues that there has been a series of rolling recessions impacted by the Covid-19 pandemic (i.e. a services recession during the pandemic with a goods boom and a sharp reversal once the economy opened up again)….Makes sense!

Quote of the week

“With strong growth we worry about the FED. Weak growth we worry about earnings”

Market Outlook for second half of 2024

Our Global Financial Markets Outlook for the second half of 2024 will be sent to clients on Monday morning. The report is full of actionable investment ideas and up to date market commentary.

Have a great weekend

Alan