Central Banks Start to Capitulate
This was quite a week. We all know you can get some big market movements during times of crisis. That’s to be expected. But you don’t generally see big shifts during sleepy summer months when half the world (or at least France) is on vacation and the economic backdrop is blah (not great, but not bad).
But central banks can still surprise us. Things kicked off on Tuesday when the European Central Bank (ECB) president hinted at possible rate cuts this year. Mario Draghi said the ECB would consider in the coming weeks how to adapt their policy tools “commensurate to the severity of the risk” to the economic outlook. The key part of his speech was as follows:
“Further cuts in policy interest rates and mitigating measures to contain any side effects remain part of our tools. And the APP (asset purchase program) still has considerable headroom.
If the crisis has shown anything, it is that we will use all the flexibility within our mandate to fulfil our mandate — and we will do so again to answer any challenges to price stability in the future.”
Well this wasn’t expected. We know European growth sorta stinks (the Bundesbank warned on Monday that Europe’s biggest economy may shrink in the second quarter). But more asset purchases? More rate cuts deeper into negative territory? This got people’s attention.
The Fed Tees Up a July Cut
Then we had the Fed announcement on Wednesday. People thought Chairman Powell would strike something of an accommodative tone, but at the last meeting he downplayed the need for more stimulus. After all, he argued just six weeks ago that the recent fall in inflation was likely to be transitory. His working assumption was that sub-4% unemployment would ultimately lead to faster wage growth and ultimately higher inflation. No soup (rate cuts) for you!!
However, over the last few weeks the data hasn’t moved his way. For example, as you can see below, unit labor costs continue to soften, and this likely means core inflation will move even lower in the months to come.
Manufacturing is also on the back foot. Both the New York and the Philly Fed manufacturing surveys have fallen dramatically (yellow line below), and the national ISM number is close to a contractionary level (anything below 50 signals a manufacturing recession – currently 50.7).
So, the thought was Powell would speak softly but really say nothing. Again, most everyone was surprised. Specifically:
- Rates were left unchanged as expected.
- However, Powell sent a pretty clear signal that rates will be cut at their next meeting in July.
- 8 out of 17 FOMC participants are now projecting rate cuts this year, with 7 calling for 50bps of cuts. During his press conference, Chairman Powell said that even the officials with a flat rate path see a stronger case for a rate cut.
- The Fed will no longer be “patient” regarding future policy adjustments. Instead, the Fed is now ready to “act as appropriate to sustain the expansion”. St. Louis Fed President Jim Bullard dissented for an immediate rate cut.
- The long-run estimate for the equilibrium Fed funds rate came down from 2.75% to 2.50%. So much for Powell’s comments last year that the Fed was a “long way” from neutral.
- The new economic forecasts do not have inflation returning to the 2% target until 2021 (the previous forecast had core inflation at 2% throughout 2019-2021). So much for Powell’s recent comments that the latest soft inflation figures are “transitory”
Right after the announcement the market moved to price in at least two cuts this year. As you can see below, the odds of at least two cuts by year-end now stand at 75%. There is a 35% chance of at least three.
This is stuff you normally see during a recession or budding financial crisis. But growth this quarter might come in at +1.5%. Job growth persists. Markets are close to all-time highs. Are you not entertained!!
What are the implications of both the ECB and Fed meetings this week? We see two key ones:
1) It will take something dramatic to prevent rate cuts over the next month. The Fed is sending a message they want to move, and unless we get some exceptionally strong data between now and the end of July they will take rates down by at least a quarter point. The ECB is likely to do the same as well as restart their QE program.
2) The other major takeaway is that the Fed’s focus specifically has totally changed. They have gone from wanting to normalize policy (raise rates, end QE) to trying to sustain the expansion. This is a big change. They are going to err on the side of accommodation from here on out unless something changes on the inflation front.
Bond Markets Price in a New Paradigm
Equity markets rallied on the news, the dollar sold off, and gold did well. But let’s focus on the bond market. U.S. 10-year yields briefly dipped below 2% and the yield on the German 10-year bond pushed to all time lows, as you can see below.
At one point this week Swiss 30-year bonds had a negative yield!!
But it’s not just Switzerland and Germany. The chart from Charlie Bilello below shows the yield curves for select countries. As you can see, Swiss yields are negative out to 30 years. In Germany and the Netherlands the red goes out to 15 years. Only in the U.S. is the entire yield curve in positive territory.
Finally, this week the total amount of bonds yielding less than 0% around the world hit $13 trillion, a new record.
This is something else. Few would have predicted this ten years into an economic recovery with falling unemployment rates in most of the developed word. Yeah, there’s not much inflation. But we don’t have 2008/2009 deflation either. But what we have is captured by a relatively new word, at least as it relates to economics – Japanification.
The U.S. stands out though. No negative yields here. We might be actually on the cusp of modestly higher long-term yields if the Fed follows through with a series of cuts. But what about during the next downturn? For what it’s worth, the Fed appears to be laying the ground work for a negative Fed Funds rate if and when the next recession rolls around.
Never Too Soon to Think of Ski Season
Now this will annoy a number of people, maybe most people. But for a fringe element this is an exciting time.
Today is the summer solstice. This means the days will now get shorter and ski season is in sight!!!
Of course, the summer solstice is the longest day of the year in the northern hemisphere. How much daylight should we get? Between 14.5 to 15 hours in the Bay Area. Fairbanks is looking at about 24 hours of sunlight.
So how should we celebrate? One of the more popular celebrations is at Stonehenge. Pagans call the day Litha and the day is framed as a battle between light and dark. It also seems to include a lot of drinking.
Chichén Itzá sounds like a good place to be:
“The precise construction and engineering of the pyramids create a visual display twice a year in which the central pyramid of El Castillo is bathed in pure sunlight on one side and full shadow on the other. Thousands of spectators, both religious and pagan, come from near and far to celebrate the solstice in view of this ethereal spectacle, in which the pyramid appears to be cut in two.”
Somewhat closer to home in New York:
“June 21st isn’t just about the Summer Solstice—it also happens to be International Yoga Day, a time of reflection and striving for inner peace. Last year, 11,000 yogis rolled out their mats during Solstice in Times Square for meditative stretching sessions held throughout the day.”
As it turns out days on earth have been getting progressively longer throughout earth’s history. This is largely due to something called tidal friction that is slowing down our spinning orb. 350 million years ago a full day was slightly less than 23 hours long. Some think a day was only six hours right after the earth was formed.
However, today isn’t the longest day ever. You have to go back to the summer solstice in 1912 to find this. Apparently melting glaciers can speed up the earth’s rotation. This is a good read on the subject.
Have a good weekend.
Published by Gemmer Asset Management LLC The material presented (including all charts, graphs and statistics) is based on current public information that we consider reliable, but we do not represent it is accurate or complete, and it should not be relied on as such. The material is not an offer to sell or the solicitation of an offer to buy any security in any jurisdiction where such an offer or solicitation would be illegal. It does not constitute a personal recommendation or take into account the particular investment objective, financial situations, or needs of individual clients. Clients should consider whether any advice or recommendation in this material is suitable for their particular circumstances and, if appropriate, see professional advice, including tax advice. The price and value of investments referred to in this material and the income from them may fluctuate. Past performance is not a guide to future performance, future returns are not guaranteed, and a loss of original capital may occur. Fluctuations in exchange rates could have adverse effects on the value or prices of, or income derive from, certain investments. No part of this material may be (i) copied, photocopied or duplicated in any form by any means or (ii) redistributed without the prior written consent of Gemmer Asset Management LLC (GAM). Any mutual fund performance presented in this material are used to illustrate opportunities within a diversified portfolio and do not represent the only mutual funds used in actual client portfolios. Any allocation models or statistics in this material are subject to change. GAM may change the funds utilized and/or the percentage weightings due to various circumstances. Please contact GAM, your advisor or financial representative for current inflation on allocation, account minimums and fees. Any major market indexes that are presented are unmanaged indexes or index-based mutual funds commonly used to measure the performance of the US and global stock/bond markets. These indexes have not necessarily been selected to represent an appropriate benchmark for the investment or model portfolio performance, but rather is disclosed to allow for comparison to that of well known, widely recognized indexes. The volatility of all indexes may be materially different from that of client portfolios. This material is presented for informational purposes. We maintain a list of all recommendations made in our allocation models for at least the previous 12 months. If you would like a complete listing of previous and current recommendations, please contact our office.