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Expect the unexpected

Dec 09 2019 09:07
Maarten Mittner

When looking back, 2019 will be remembered as yet another year in which central banks came to the rescue of global markets and the worldwide economy.

Against the backdrop of waning economic growth, adverse economic data and sagging equity markets, the US Federal Reserve (Fed) stepped in and reduced interest rates on three occasions. 

That provided renewed support to equity markets, with the S&P 500 in record territory at the end of November.

At the beginning of 2019 the Fed was set to continue its hiking (or normalisation) stance. 

But amid a mini taper tantrum in the markets – not least accompanied by vituperative pressure from President Donald Trump – Jerome Powell and his team at the Fed reversed course, showing sensitivity to the message the bond market was sending out. 

And that was that the Fed had overextended itself and was too hawkish, having hiked rates to a range of around 3% in the preceding two years.

In the third quarter of 2018 the yield on the benchmark US 10-year bond was at 3.2%. 

In 2019 it fell to a low of 1.4% as prices rose, before easing somewhat to 1.9% in mid-November. 

But the message from the bond market is still clear: The Fed must remain relatively dovish if there is to be continued economic growth. 

And that’s the only way to avert a recession.

Meanwhile, the European Central Bank (ECB), in the final months of stewardship under “whatever it takes” Mario Draghi, also changed course, realising that without some or other form of stimulus, the European economy would falter. 

The ECB resumed its quantitative easing stance, despite the fact that rates are already flat or negative, thereby minimising the extent to which the central bank can address matters.

Under the new leadership of previous IMF head Christine Lagarde, the pressure is mounting on countries with healthy economies, notably Germany, to embark on extensive fiscal stimulatory measures to boost the ailing European economy. 

Already there has been some criticism from German bankers that Draghi misdiagnosed monetary policy in identifying deflation in the Japanese model as the major problem. 

According to the bankers, deflation did not occur, and Draghi therefore erred, probably not realising that it was precisely because of Draghi’s stimulatory policies that deflation did not happen. Touch wood. 

Lagarde has laid down the rules for Germany, emphasising that Germany is but one of 28 countries in the EU, and that it’s expected from the frugal Germans to fall in line with the rest of the more expansionary member states.

For 2020, the macro risk areas are clearly delineated. 

These include the trade tensions between the US and China, which has had an adverse effect on global trade. 

World economic growth needs to be revived. In March 2019, Chinese industrial production topped 9%. Now it is at 4.3%. 

In the US, growth in the manufacturing sector is in negative territory from 2.4% in January. 

Further risk areas include the ongoing Brexit saga in the UK, regional unrest in the Middle East and troubles in Hong Kong possibly spreading to mainland China.

However, if 2019 is anything to go by, risks may be developing in unexpected areas. 

For if 2019 taught markets one thing, it’s that a hiccup can occur where it is least expected.

In September, for example, the normally staid and placid US repo market was severely jolted when interest rates suddenly spiked to 10% amid a severe lack of liquidity, nearly causing a major financial upset. 

To this day, the Fed continues to pump in billions of dollars to support the repo market. 

Rates have stabilised, after having shot up way above the intended range of 1.75% to 2% as banks scrambled to obtain the necessary funds to meet daily obligations.

But the jolt clearly illustrates the challenges created by the Fed’s hawkish stance. 

Then there was the strange development of inverted bond yields, with short-term yields rising above long-term yields in a rising equity market environment, clearly indicating extensive risk-off trade where investors sought the relative safety of longer-dated investments. 

Short-term investments were deemed to be too risky, against the backdrop of lower growth and a possible recession. 

It therefore seems likely that any unexpected crisis in 2020 will in some form or another be linked to market liquidity. 

Further pressures may emanate from lower earnings growth at US companies. 

The state of consumer spending in the US also remains crucial. 

It did receive some reprieve from the more dovish Fed, and Trump’s earlier tax cuts. 

However, high levels of corporate debt could present an emerging crisis. 

Any default in this market is bound to cause a ripple effect, of which the consequences could be very damaging.

Historically, markets always experience a crisis at some point in time. 

Easy money leads to bubbles, where the real value of money is lost in the fog of inflated expectations. 

Usually, little can be done about this, other than to cheapen the value of money again. 

That in itself presents renewed problems. Much, therefore, again depends on the Fed in 2020. 

The Fed anticipates a period of steady rates at present levels, still keeping its eye on economic data. Already this stance is causing jitters in some circles. 

But higher yields in the bond market show that some stability has been regained as markets enter the new year. 

Maarten Mittner is a freelance financial journalist and a markets expert.

This article originally appeared in the 12 December edition of finweek. Buy and download the magazine here or subscribe to our newsletter here.

bonds  |  markets
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