Macro economic commentary – September 2018

Author: Ntsekhe Moiloa

In early September, the US Federal Reserve published a note on its website discussing estimations of the long-term neutral rate of interest. Also known as r-star, in theory such an interest rate induces neither saving nor spending. Most efforts to achieve this interest rate nirvana have focused on short-term rates, however, John Roberts proposes in the note that policymakers rather consider targeting the ten-year rate. From about 1970 to 1995, Roberts estimates the long-run neutral real 10-year rate to have hovered just below 4 percent before beginning a gentle decline towards the current level of about 0.75 percent. It turns out that 10-year TIPS are most recently trading at around 0.9 percent; these were about 20 basis points lower at the start of the third quarter of this year.

It is however more popular to calculate short-term models focused on the equilibrium Fed Funds rate. The Fed raised interest rates as expected towards the end of September. Ordinarily that would seem like an uncontroversial move, given that it was what the consensus expected. However, what is significant is that the market’s consensus is below the Fed’s own dot plot level, meaning that the members of the FOMC missed an opportunity to demonstrate conviction about their own dot plot trajectory. In a sense it was as though they were more inclined to believe the suggestion from long-term models that suggested that interest rates might already be close to where they need to be. Additionally, the meekness of the hike tended to suggest that the Fed is cautious about throttling off growth in the United States, as though the Fed does not fully trust the strength of the US economy to shoulder higher levels of interest rates. There is an additional interpretation of the Fed’s reluctance to move interest rates higher: it is that interest rates are close to its own definition of a neutral policy rate, that being somewhere around 50 to 100 basis points above the inflation target. The inflation target for the US is about 2 percent, so a Fed Funds rate somewhere between 2.5 percent and 3 percent would seem to be the Fed’s ideal range. Following the latest hike, the FOMC has moved the range to between 2 and 2.25 percent, implying that there may be two more increases ahead.

The market expects another hike this year and a few more next year. That the Fed seems to be more reluctant than the market is perhaps not a bad thing for emerging markets. Several emerging markets including South Africa have too-slow growth problems, rather than too-fast growth problems. The monetary policy temptation when faced with a too-slow growth problem is to cut interest rates. If South African rates were coming down the ladder while US rates were going up the ladder, that would squeeze the interest differential between the two countries, piling pressure on the rand. Weak, inflation-importing currencies in the midst of anemic growth, are policymakers’ migraines. Thus, a slower-than-expected pace of US hikes would have better global consequences than a faster pace.

To be sure, the Fed Funds rate has been much higher than 3 percent in the past. Just before the Great Financial Crisis it was slightly above 5 percent. The sense that the Fed is approaching a medium-term upper bound to policy rates is not anchored in history but rather by the institution’s own sense that it makes no sense to rush to raise rates when the gradient of economic growth is expected to come down shortly. As matters stand, there is a policy dissonance present, where monetary policy is gradually tightening while fiscal policy is being loosened via deregulation and tax cuts. It might charitably be called a rebalancing that restores dry powder to the monetary toolbox without slowing down asset growth, but we are aware of the Fed having assessed asset prices to be elevated. Furthermore, economists consider it a special kind of madness to add stimulus at the tail end of an economic cycle because it reduces fiscal space to counter-steer when the economy actually starts to need a fiscal jolt.

A question which we have found asked with regularity is when the next global recession is due. While it is difficult to pin a date on the next recession of scale, the Fed’s messaging is clear and will get ever clearer over the next half year, namely that the trajectory of economic growth is going to come down, soon.

The US Treasury market also has a story to tell. At the beginning of the year, 10-year yields were about 80 basis points above 2-year yields. That premium has squeezed down to about 20 basis points and so there is not a lot of distance to go before that curve inverts. Inverted yield curves have historically been a sign of diminished expectations for economic growth, although we note that the record of this signal has been mixed – it does well at anticipating recessions that materialise but has also anticipated recessions that never materialised.

In contrast to economic slowdowns, economic crashes are notoriously difficult to identify in advance. Analysts commit considerable energy to guessing when the next crash is due, however we should be clear that these are best guesses despite clients’ desire for precision. It is arguably more important and useful to think about the trajectory of growth, especially in the US. The US twin deficit – the sum of the fiscal deficit and the current account deficit – is estimated to be about 5.9 percent currently, consisting of a 2.2 percent current account deficit and a 3.7 percent fiscal deficit. Factoring in the Trump tax cuts, the actual deficit could be higher. For context, South Africa’s current account deficit was last estimated at about 3.2 percent of GDP while the fiscal deficit is estimated at about 4.2 percent of GDP, yielding a twin deficit of about 7.4 percent. The UK has a twin deficit of 5.5 percent; Argentina has a twin deficit of 5.8 percent; Brazil has a twin deficit of 8.0 percent; and Turkey has a twin deficit of 8.5 percent. France has a twin deficit of 3.1 percent, China has a twin deficit of 3.2 percent while Germany has a twin surplus of 9.4 percent. The point is that as far as twin deficits go, the United States is currently registering figures closer to emerging markets than to other more advanced markets. Part of the ability of the US to run high twin deficits has been its special place in the post-Bretton Woods pantheon, funding its own and the world’s growth, to the ire of people like Donald Trump. It is somewhat ironic that Trump’s tax cut continues that tradition. However, another part of why the United States has been able to run an emerging market-like twin deficit is because nominal GDP growth has been strong, papering over the deficits. When nominal GDP growth slows appreciably, we may see concern transmitting through a weakening dollar, provided there is not a crash brought about by an event elsewhere in the markets. In the event of a crash, all bets are off because the US dollar will almost certainly benefit from a safe-haven effect.

The combination of forces we have described weighs in favour of relative rand strength, barring a sudden and unexpected shock to global financial markets or an idiosyncratic domestic shock.

A few months ago, we thought that a rupture might come through a rapid depreciation of the Chinese currency. That has, however, not happened. While the US dollar has strengthened against Chinese renminbi, it does look as though the move can be adequately attributed to interest rate differentials. The interbank overnight spread between the two currencies has contracted nearly 300 basis points since the beginning of the year. About 200 basis points of that narrowing is due to Shanghai LIBOR decreasing, while about 50 basis points seems is the extent of US interest rate hikes. About five-sixths of the spread differential is the sum of those two factors. Overlaying the inverted spread differential on the actual currency cross-rate over the past decade reveals a picture where the dollar-renminbi rate appears to largely mimic changes in the interest rate differential. That relationship appears to remain intact.

We continue to contemplate where ruptures might be a threat. Our sense is that these will again be at the intersection of Main Street and Wall Street. Deregulation on Wall Street raises the probability. It is attractive to attempt to sniff out new problems in new places, but should we rather be returning to the scene of the last crime? US property prices have been rising faster than wage growth over the past few years, and zero-percent-down lending is happening again. Furthermore, synthetic CDOs are back from the dead. How Frankenstein are synthetic CDOs? Their gestation goes something like this: a number of mortgages may be pooled into a mortgage-backed security. Likewise, a number of car loans. These two pools and others might be joined together into a collateralized debt obligation, a CDO. The CDO would be sliced into tranches ranging between less risky and riskier slices. The holders of the riskier slices might get nervous and ask for insurance. The arranging bank may issue credit default swaps, a form of insurance, for a premium of course. But few banks are fools and would likely look for hyper-risk-takers who would accept a pool of CDS on risky CDO tranches. The banks would take a fee on arranging yet another CDO variant and presto, a synthetic CDO would be born. It is the re-emergence of such structures that warrant a close eye because they point to a level of risk-taking that is eye-watering, especially at this point in the economic cycle.