Last week seems like a long time ago. But it’s worth pointing out that Friday’s US session saw the release of a bumper non-farm payrolls report.
The US economy created 280,000 jobs in May, with positive revisions to the March and April numbers. The unemployment rate is just 5.5%…and still the Fed persists with 0% interest rates!
The upshot is that we’re on track for higher US interest rates this year, which is bullish for the US dollar and bearish for commodities and emerging markets. From Bloomberg:
‘Emerging-market stocks dropped for an 11th day, the longest losing streak since September 1990, on growing concern that the U.S. will raise the near-zero interest rates that have buoyed demand for assets in developing nations.’
A strong dollar partly reflects speculative capital flowing out of emerging markets. And because many emerging economies have borrowed in US dollars over the past few years (which they have to pay back in their depreciating currency) US dollar strength represents a nasty feedback loop.
But you’d have to think that the first interest rate hike by the Fed since Roman times is now priced in, wouldn’t you? I mean, we’ve had many months of strong employment gains and plenty of comments from Fed boss Janet Yellen that a rate rise is on its way.
The only question is around timing. After that, it’s about what effect the rate hike will have and, if it’s benign, how long until the next one?
Maybe that’s looking too far ahead. Maybe Greece will pull out of the Eurozone or maybe the end of the business cycle is close at hand and you won’t see a rate rise at all. In the Fed’s world, the only solution for uncertainly is keeping the interest rate pedal to the floor.
Keep in mind that we’re now into the sixth year of an economic expansion. And the Fed has kept interest rates at 0% the whole time.
Former Fed governor Lawrence Lindsay worries about this policy stance. A few weeks ago, at a conference with other former Fed chiefs like Alan Greenspan, he said,
‘We’re delaying a normalization of rates way, way beyond what is prudent. We have a monetary policy that’s now in place that was adopted for the crisis conditions of 2008 and 2009. This summer we’re going to be getting the seventh year of this recovery. It’s been a lousy recovery, but it’s still the seventh year of a recovery.
‘That is totally inappropriate. The unemployment rate is essentially at what economists call “NAIRU” [Non-Accelerating Inflation Rate of Unemployment]… When I went to school, you’d be laughed out of the classroom if you said the right interest rate when unemployment rate was five four [5.4%] was zero – it was just the most preposterous thing you could imagine.
‘Or that the Fed should have quintupled its balance sheet in five years. We’re at the point of absurdity. Maybe it made sense when you had a crisis. It does not make sense now. At some point what is going to happen – and this gets to my eight or nine cataclysmic number [on a scale of 1 to 10] – is that we’re going to get a series of bad numbers – a little higher inflation, higher average hourly earnings or whatever – and the market is suddenly going to say, “Oh my God, they are so far behind the curve that they will never catch up.”
‘And the market is going to force an adjustment on the Fed that will be wrenching. That’s the cataclysmic outcome. If the Fed were to get a little bit ahead of the curve – or even maybe move a little bit closer to the curve – that’s the best we can hope for – we would mitigate that. We would phase into it gradually. And that’s why so much is at stake in the monetary policy that we adopt now…’
I quoted at length because it’s such an important point. We’ve become so desensitised to risk – thanks to the power of low interest rates — that we think what’s happening now is some sort of normal.
It’s not. Historically, it’s completely abnormal. Just recently, interest rates in some European bond markets were the lowest in history. That’s despite there being record high debt levels in most of its economies.
If the Fed is thinking even a little bit like Lawrence Lindsey, then they will understand the need to start raising interest rates as soon as possible.
As far as I can tell though, it’s all too late. Now, they’re damned if they do and damned if they don’t. Raising interest rates too fast will have grave implications for a highly indebted global economy. But if they continue to take the very slow path to interest rate normalisation, they’ll have no firepower for when this cycle turns down, which it inevitably will.
Where Australia fits into all this is difficult to tell. My guess is that we’re more in line with the emerging market economies. The Bloomberg quote above said emerging markets had been down for 10 days straight. We’re not far off that either.
As you can see in the chart below, the ASX200 has pretty much given up all its 2015 gains, with a good part of that decline coming in just the last week or so.
Interestingly, much of the weakness is coming from the banking sector, which was for years considered highly defensive.
For example, Westpac [ASX:WBC] shares are now at the lowest point since February 2014. ANZ [ASX:ANZ] and NAB [ASX:NAB] are perilously close to breaking to new yearly lows as well. Only the Commonwealth Bank [ASX:CBA] is keeping its head above water.
This is ominous. It’s telling you the iron ore bust (which translates into a terms of trade and national income bust) is now making its way to the heart of the Aussie economy…the banks.
Without further interest rate cuts, the banks will remain under pressure. Sadly, monetary policy is the only policy lever we’ve got. Falling revenues and built-in spending increases make fiscal policy ineffective as a tool to boost growth. And structural reform is out of the question thanks to a timid political class and an electorate in denial.
That means Australia has the opposite problem to the Fed. That is, the next move in interest rates here will be down, but the question is when? More to the point, the question is how much more can we cut rates before our offshore creditors start to get nervous?
One thing is for sure. If the Fed raises rates and the RBA keeps cutting, the Aussie dollar will head into the 60s by year end.
A falling dollar is a sign that creditors see Australia as a riskier investment destination. It also makes imports more expensive and thus puts upward pressure on inflation. That in turn makes it more difficult for the RBA to keep on cutting rates.
But they will keep cutting until the market tells them to stop. With business investment set to fall sharply next financial year, jobs growth will remain weak in Australia. The RBA will have no option.
Will more interest rate cuts be enough to fire up the banks and the stock market in general? It’s worked in the past…so there’s no reason to think it won’t work again.
But apart from a possible interest rate induced bounce, in my view the banks represent a poor risk/reward pay off. This is what I wrote to Sound Money. Sound Investments. subscribers about it in a report early last month…
‘What used to work isn’t so much of an easy bet now. As a result, you’re going to see investors increasingly shift capital from the banks and financials into the more overlooked parts of the market.
‘It will trigger a search for value as investors realise the banks have already seen their best days in terms of profit growth.’
If you want to find out which sector is set to benefit most from the fall in the banks, click here.
For Markets and Money