Wealth Intelligence Weekly 23 Sep 2019
A hawkish cut and a dovish hold
Last week, the two most important central banks for local investors held monetary policy meetings. The US Federal Reserve (the Fed) is arguably even more important for local investors than the SA Reserve Bank (SARB). While the SARB sets short-term rates for the local economy, and in doing so anchors the yield curve of the local bond market, the Fed's decisions impact sentiment for global markets in their entirety. Central bankers are traditionally described as hawks or doves, with the former taking a tougher stance on inflation and preferring higher rates, while the latter will argue for lower rates. Though it cut rates, the Fed's stance was probably a bit more hawkish than the market expected, while the SARB is on hold. A cut later this year is still likely.
Fed Chair Jerome Powell was at pains to argue that they still saw the US economy as being in good shape, led by strong consumer spending on the back of a healthy labour market. However, persistently weak inflation, the uncertainty generated by a weak global economy and President Donald Trump's trade wars, resulted in a second consecutive rate cut. In other words, rather than responding to weakness in the US economy, the Fed is recalibrating its interest rate stance to better reflect the risks. Powell and his colleagues also reiterated that they were ready to act as needed to sustain the US economic expansion, now in its 11th year. Further cuts could follow if needed, but the Fed is careful to avoid the perception that it will necessarily reduce rates. It is a tricky balancing act.
After the 25 basis points cut, its policy interest rate (the federal funds rate) now sits in a range of 1.75 to 2%. The path forward is less clear. Two voting members of the Fed's rate-setting committee voted against a cut, while one member wanted a much larger cut. The summary of economic forecasts from committee members and regional Fed presidents - the socalled dot plot - also shows a divergence of views on where rates are likely to move next. The median dot in the plot indicates no further rate cuts this year or next and none of the dots are below 1.5%, even though markets are still pricing in the federal funds rate falling below that level. Since the Fed started producing the dot plot, the market has been right more than the dots. All in all, the Fed under Powell has shown itself to be pragmatic and ready to respond to changes in underlying conditions. But this pragmatism means it is difficult to communicate about what the future might hold.
The Fed's cuts are less relevant to the US economy than one might think. A large proportion of business and consumer loans are linked not to the Fed's policy rate, but to other market interest rates. These of course came down sharply from late last year in anticipation of Fed easing. For instance, the benchmark 10-year Treasury yield plunged from above 3% late last year to 1.5% earlier this month, pricing in much lower growth, rates and inflation. It has since backed up a bit to 1.8%, as some macro risks have receded. But this means that the interest rate on a typical American home loan, for instance, has fallen from 5% to 4%, a significant saving for new buyers or an opportunity for existing homeowners to refinance and save. As a result, there has been an increase in activity in the important US housing market since the start of the year, from sales to new construction. In other words, the Fed's role is more in setting expectations than in determining actual borrowing costs. It also has to fight fires in financial markets when they break out. Last week saw short-term interest rates spike in a corner of the money market, to which the Fed responded by providing additional liquidity. If the problem recurs, it will probably be forced to start expanding its balance sheet again and creating additional bank reserves.
One person who is not happy is Donald Trump himself, who immediately took to Twitter to demand much lower rates. The Fed, however, has maintained that it will not bend to political pressure, but make decisions based on what's right for the economy.
It is true that the global debate on monetary policy shifts as economic conditions change. The dominant operating paradigm of central banks tends to be to fight the last war. The depression of the 1930s gave way to demand-side management in the post-war year. The stagflation of the 1970s gave rise to central banks targeting inflation (but ignoring financial stability concerns i.e. too much risky borrowing). In the post-2008 crisis, central banks in the developed world have tightened up bank regulation and deployed new tools (quantitative easing, forward guidance, negative rates) in the face of persistently low inflation. The basic principle of independence remains, but this could still change. Developed market central banks have lacked success in stimulating growth and inflation over the past decade, and do not have much firepower left to fight the next recession, if it hits. We might find ourselves talking about close cooperation between fiscal and monetary authorities in years to come. Japan is at the forefront here, with the Bank of Japan already owning a quarter (and rising) of outstanding Japanese government bonds.
But for the time being, central bank independence in emerging markets is sacrosanct. Investors simply don't trust these governments to act responsibly, and unlike the rich world, inflation is still alive. A quick glance at Argentina and Turkey's exchange rates and bond yields will demonstrate what an emerging market without a credible central bank looks like.
This brings us back home. The Reserve Bank's Monetary Policy Committee (MPC) faced a number of cross currents in arriving at its interest rate decision last week. Consumer inflation was a little higher than expected in August, but at 4.3% remains below the midpoint of the target range. Food inflation has bottomed and should continue rising from the current pace of 3.8%, but unlike previous cycles, is not expected to hit double digits. Core inflation, excluding volatile food and fuel prices, was also at 4.3%. Importantly, consumers, workers and business leaders are starting to get the message that inflation is lower, according to the Bureau for Economic Research's inflation expectations survey. The MPC wants lower inflation expectations, as these tend to feed into lower realised inflation.
The economy performed better than expected in the second quarter, but there is no indication that this strong upward momentum will be sustained. The underlying growth picture is still gloomy and the SARB expects growth of 0.6% this year and only 1.5% next year (the previous forecast was 1.8%).
The jump in the oil price following attacks on Saudi Arabian oil facilities by Yemeni rebels has largely reversed itself, as it appears the damage can be repaired fairly quickly. The petrol price hike next month should therefore be fairly small. However, there could be another attack, and crucially, the US accusation that Iran is behind it all means the decades-long standoff between the two could escalate.
The rand has also weakened since the July MPC meeting, when it was trading at R13.90 to the dollar. But the rand remains within its broad trading range of the past four years. Friday's closing level of R14.90 per dollar was first breached in December 2015.
And then there are the fiscal risks. The government is expected to make an announcement on how it expects to resolve the Eskom crisis in the coming days. This will be followed by the Medium-Term Budget Policy Statement in late October, which will present an update on government's borrowing requirement. Moody's are scheduled to announce a ratings decision on 1 November 2019. They have largely (but not completely) ruled out a downgrade, but a change in outlook from stable to negative is likely. If any of these events turn out differently to what the market expects, the result could be a sell-off in the rand and local bonds. By the same token, a better-than-expected result could see a rally in bonds.
Helping the case for a rate cut is that global central banks are still cutting in droves. Apart from the Fed, 12 other central banks have cut rates this month (against three hikes), including Russia, Chile, Indonesia and Brazil. The Bank of England and Bank of Japan kept rates unchanged last week. The risk, though probably small, is that the market has completely overestimated the extent of the cuts, which could lead to sharply higher bond yields in developed markets, and capital outflows and weaker currencies in emerging markets.
Faced with this long list of ifs, buts and maybes, the conservative Reserve Bank kept the repo rate unchanged at 6.5%, which means the prime overdraft rate of banks remained at 10%. The 21 November 2019 meeting is a more likely candidate for a rate cut.
Since consumer and business loans tend to be linked to the prime rate, the SARB has a direct impact on the cost of credit in the economy. These borrowing costs are well above the rate of inflation and act as a drag on the economy. However, the SARB's cautious nature and independent decision making also act as a very important anchor of our credit rating and supports our standing among global investors. For us as local investors, we continue to see local short-term and long-term interest rates as attractive, given a muted outlook for local inflation and a declining global interest rate trend that is very much still intact.