Central Bank Accommodation Is An Addiction

  • The Fed follows the ECB as both loosen credit
  • Eurozone rates could be heading for Swiss levels
  • The slowdown in China is for real
  • Brexit could cause lots of contagion
  • Another round in the global liquidity bonanza- Keep those rates low as the cost of financing debt is staggering

In the Merriam-Webster dictionary, one of the definitions of addiction is persistent compulsive use of a substance known by the user to be harmful. Since the 2008 global financial crisis, central banks around the world have pumped unprecedented amounts of liquidity into the global financial system. Historically low interest rates and asset purchases have kept rates low along the yield curve to simulate economic conditions. Aside from the stimulus, the low rates have also lowered the price tag when it comes to financing government debt. Negative rates of interest in Europe and Japan not only cause the value of money to decline over time but result in shrinking levels of government debt if it were to remain constant. While debt levels have gone nowhere but higher, the cost of funding is controlled by the low level of rates. At the same time, liquidity has eaten away at the value of fiat currencies. Perhaps the best example of the devaluation of legal tender in the world financial system is the trend in the price of gold, the world’s oldest means of exchange. The yellow metal has appreciated in all currency terms since the early 2000s.

While the global financial crisis of 2008 has faded in the market’s rearview mirror, the world’s central banks remain addicted to stimulus. Over the recent weeks, the two leading monetary authorities told markets that accommodative monetary policy would continue, and in some cases accelerate. The bottom line is that the addiction to liquidity is like a heroin habit. The withdrawal has become a consequence that politicians and economists want to avoid at all costs.

The rise in the price of gold in all currency terms is a consequence of currency devaluation around the globe. It is also a sign that while central banks complain that inflation is below a hypothetical 2% target rate, that it may come roaring back with a vengeance in the future. One of the principles of physics is Newton’s third law. For every action, there is an equal and opposite reaction. The stimulus is inflationary, and central bank monetary policy accommodation comes at a price. How long will it take before the world’s central banks are looking down instead of up at that 2% inflation rate?

The Fed follows the ECB as both loosen credit

On July 31, the FOMC delivered on its pledge to pivot to a more accommodative approach to monetary policy. The Fed cut the short-term Fed Funds rate by 25 basis points to a 2.00-2.25% range. At the same time, the central bank ended its balance sheet normalization program one month early.

The move disappointed markets. Many market participants expected a move of 50 basis points as an initial statement to stimulate the US economy in the face of low levels of inflation and uncertainty over economic conditions in China and the Eurozone. The decision was not unanimous as two members of the committee, voted against cutting rates. Eric Rosengren and Esther George dissented in an 8-2 vote. Finally, and most significantly, Chairman Jerome Powell attempted to walk a fine line when explaining the rate cut in the face of a robust US economy and threats from abroad. The markets did not like when he said that a mid-cycle rate cut did not preclude future increases in the Fed Funds rate. And, stocks and other market hated his statement that the central bank has not entered a prolonged period of accommodation.

However, Chairman Powell may have to eat those words as the US economy does not exist in a vacuum. President Trump expressed his dismay with the Fed’s performance at the July meeting. On August 1, the announcement of new tariffs on China is a reason that more rate cuts could be coming a lot sooner than the Fed Chairman led the markets to believe.

Meanwhile, at the most recent ECB meeting, President Mario Draghi told markets that he is prepared to cut rates further and use quantitative easing to stimulate the European economy. Aside from sluggish growth, Europe now faces the rising potential for a hard Brexit now that Prime Minister Boris Johnson is in charge of the show on the UK’s side. Falling European rates will put further pressure on the US to cut rates. The dollar index rallied in the aftermath of the rate cut because the market appears to believe that Europe will provide stimulus quicker than the US.

Source: CQG

As the weekly chart shows, the dollar index rose to a new and higher high at 98.700 on the nearby futures contract after the Fed rate cut last week. The pattern of higher lows and higher highs since the February 2018 low remains intact. The rate differential between the dollar and the euro currency is a significant factor when it comes to the path of least resistance of the dollar index. The euro comprises 57% of the index.

The action in markets following the Fed moves last week could be telling us that the central bank stopped short of sending a meaningful message to markets.

Eurozone rates could be heading for Swiss levels

Mario Draghi told markets to expect even lower interest rates than the current level at negative forty basis points. However, he has room to slash rates even further considering that Switzerland had been a trailblazer with a short-term deposit rate currently at negative 75 basis points. The US dollar rallied after the move by the Fed on July 31. The currency market realizes that while the yield differential narrowed between the dollar and euro in the short-term, the statement by the ECB President means that the euro rates are going lower. Chairman Powell was far less convincing when it comes to the path of US rates.

At the same time, the trade developments last week mean that the Chinese yuan will move lower against the dollar as the trade dispute evolves into a currency war. Last week, President Trump dismissed a proposal to intervene in the currency market to push the dollar lower. However, frustration with the Fed could put that potential back in play. The President has accused both China and Europe of currency manipulation, and he may find his administration in a position where it decides to fight fire with fire.

The slowdown in China is for real

The economic impact of more tariffs on another $300 billion in Chinese goods coming into the US is another nail in the coffin when it comes to economic growth in the nation with the second-largest GDP. Last week, the price action in Chinese large-cap stocks was a sign that the escalation will have a significant impact on China’s economy.

Source: Barchart

The chart shows that the China Large-Cap ETF product (FXI) closed last week at $39.86 per share, which was the lowest level since January when stocks were beginning to recover from the Q4 selloff.

There is an old saying that when China catches an economic cold, the rest of the world comes down with financial flu. The escalation of the trade dispute with the new 10% tariffs presents a problem for markets across all asset classes. Copper is a bellwether industrial metal and often serves as a barometer of global and Chinese economic strength.

Source: CQG

The weekly chart shows that the price of copper declined to a new low for 2019 and was closing in on the late December 2018 bottom, which was the lowest price since June 2017. Copper and the FXI are signs that trade issues are a significant problem for China. The move in the Russell 2000 small-cap index in the US could be a harbinger of the impact of the trade war on US companies.

Source: Barchart

Since July 31, the Russell 2000 index has been one of the worst-performing leading stock market indices. The slowdown in China is a casualty of the trade dispute, and its contagion on the US and rest of the world will intensify as the protectionist measures mount.

Brexit could cause lots of contagion

The new Prime Minister in the United Kingdom has told markets, in no uncertain terms, that he intends to leave the European Union and fulfill the will of the British people by October 29. Prime Minister Boris Johnson has said that he will meet the deadline with or without an agreement with the EU.

A hard Brexit will increase uncertainty dramatically for two reasons. First, from immigration to trade and borders to regulations, Europe will face a breakdown in its infrastructure. Moreover, a British departure without a deal for the future would set a precedent for other nations who chose to depart the union in the future.

The price action in the pound sterling against both the US dollar and euro currency since the Brexit referendum tells us that the pound does not relish the potential for a hard exit. Since July 2016, the pound only recovered when it looked like an acceptable deal was on the table or when the potential for the UK to remain within the EU increased. Therefore, the Prime Ministers pledge and willingness to leave without a deal could cause contagion in financial markets that ripple across the globe in a tsunami of volatility.

Another round in the global liquidity bonanza- Keep those rates low as the cost of financing debt is staggering

We are at a point in history when uncertainty is rising to unprecedented levels. The trade and perhaps currency war between the US and China increased in intensity last week. The markets told the US central bank that it is behind the eight-ball when it comes to actions to stimulate the US economy before a potential disaster. The world faces a hard Brexit in just three months. And, the 2020 Presidential election is kicking into gear. With the political division in the US, the contest is likely to be the most contentious in history.

At the same time, eleven years of central bank accommodation has caused debt levels to rise to unprecedented levels. At the same time, the US just increased its debt ceiling. Pushing interest rates lower to stimulate economies around the world also serves another purpose. Servicing debt is less challenging in a falling than a rising interest rate environment.

Falling interest rates, a currency war that accelerates the devaluation of currencies, and the declining faith and credit in governments is the reason why the price of gold was at close to its highest price since 2013 at the end of last week.  

Source: CQG

The weekly chart highlights that gold dropped as the dollar rallied and markets reacted last week’s move by the Fed. However, the yellow metal held the $1400 level and raced higher to close the week at over $1440. Gold put in a bullish reversal on the weekly chart based on the closing price on August 2. Gold is in a bull market in all currency terms, and the potential for significant price appreciation from the current level is rising. Gold is screaming that the world’s central banks have no choice but to continue to provide stimulus. Central banks are addicted to accommodative monetary policy. Nothing can power gold higher than a continuation of dovish central bankers with their hands on the wheel of the global economy.

Chairman Powell attempted to fight the addiction during his press conference last week. However, the escalation of the trade war, a hard Brexit, and the action of other central banks around the world will place that monkey on his back. The Fed will follow the markets, as they have proven over and over again. More US rate cuts are coming because there is no rehab for the path of central bank policy.