Author: Awareness News

The past weeks have been tense for the financial markets, with the stock market reacting negatively to the inversion of the Yield curve, one of the most preeminent indicators of recession in the past, which adds up to the failures registered in the last two years in making the economy dynamic again (via extremely low interest rates).

The truth is that the alarms are starting to ring in several fronts. Tensions between the US and China increased concerns among investors, and may deteriorate the whole economy, taking another step towards the recession. Investors have started to leave the common equities to take refuge in sovereign debt and gold, with the latter one being traded at around 1500 dollars (28.3% increase in the last 52 weeks according to Bloomberg), the highest since 2013.

Germany

Financial data about Germany, the strongest economy in the eurozone, also shows that an economic breakdown could be just around the corner with the country’s interests in sovereign debt negative in all the available periods (including the 30 years bonds) helping keeping the country slightly above the recession line.

The PMI (Purchasing Managers’ Index), a widely used economic activity indicator, stated a decrease in the country’s performance (43.5 in a scale from 0-100 where values below 50 indicate an expected retraction) and the industrial production registered the biggest fall of the last ten years (being affected by the US-China trade war in the exports field).

If we add up all this data to the fact that in the last year the country barely avoided a technical recession (GDP contraction for two consecutive quarters), it might be possible that the recession in the eurozone’s biggest economy is close to happening and with that its main traders will suffer repercussions.

To support this opinion, the reading of this year’s data about Germany’s economic performance is recommended, since this last quarter (April-June) the economy sank 0.1%. Next quarter prospects are not that good as well, but will depend on the markets’ reactions to the new quantitative easing programme (which will be launched in November).

Monetary Policy

Negative interest rates? Once seen as an anomaly, negative interest rates are becoming increasingly more common since the last financial crisis. Among the countries/monetary unions with «subzero» interest rates we have Denmark, Japan, Sweden (the first to adopt the strategy), Switzerland and the Eurozone.

Mainly used as an extension of the traditional monetary policy tools to avoid deflation, encourage lending and promote economic growth, these policies have lost their catalyst power, with the economy being “trapped” into an inefficient mechanism that contributes more to feed the Assets and Real Estate “bubble” than to give a temporary stimulus for a sustainable growth in the future. (Housing prices in the US are 8% higher than at the peak of the real estate bubble in 2006, and the CAPE ratio, Cyclically Adjusted Price to Earnings Ratio, that is generally applied to broad equity indices to assess whether the market is undervalued or overvalued, is also higher than in 1929 and 2008).

In fact, the bond market with negative yields already reached 17 trillions, roughly 30% of its entirety, which reveals the uncertainty amid the remaining market (not to be confused with the bond market, which is historically safe), with people willing to lose some money in order to avoid major losses.

It is also worth mentioning that these measures do not give signs of stopping, since Mario Draghi decided to restart ECB’s economic stimulus efforts with a quantitative easing programme of €2.6 tn, an act heavily contested by some of his peers in the Central Bank such as Klaas Knot, Dutch Central Bank governor, who said “this broad package of measures, in particular restarting the asset purchase programme, is disproportionate to the present economic conditions” and also “there are increasing signs of scarcity of low risk assets, distorted pricing in financial markets and excessive risk-seeking behaviour in the housing market”.

The Central Banks of Thailand, New Zealand and India have also started to cut heavily on the interest rates, more than investors were expecting, putting the monetary policy concerns into a globalised proportion.

Trade War

In the geopolitical arena, we have another big threat to the current weak balance of the worldwide economy: the worsening of the commercial tensions between the US and China, which has been speculated to degenerate into a currency war. This derives from China’s reaction to the implemented tariffs in every Chinese product applied by the US, that resulted in the devaluation of the Renminbi, with all the consequences that this measure means for the trade balance. Also regarding this topic, it is important to mention that China’s economy grew at its slowest pace in almost three decades in the second quarter of this year, as the trade war with the US took its toll on exports. Despite remaining with relatively good income and consumer spending growth rates, the year on year growth rate was “only” 6.2%, the lowest since 1992.

Maybe it is only one more episode in an endless novel, with both sides continuously failing to find a solution to their divergences, but as the time passes and the patience burns out, this might escalate into even more serious issues, with Bloomberg predicting a 0.6% decrease in global growth if the two countries expand their tariffs to all goods and services.

Yield Curve Inversion

Even more distressing is the inversion of the Yield curve of US Treasuries, that basically retracts the evolution of the 3 months interest rate versus the 10 years’ one (we can compare several periods within this range), meaning that the cost of borrowing long term is falling below that of borrowing short term, which is the opposite of what it should be. This phenomenon reflects investors’ collective uncertainty towards the current economic outlook and is thought to be the biggest warning to the markets since the 2007 recession, with investors turning to safer assets, such as the 10-year treasury bonds.

This is supported by the fact that the last 5 recessions were all preceded by one of these inversions (approximately between 12 to 18 months after). Despite this historical data, it is also important to bear in mind the economic environment we face today, since the extremely low interest rates in the eurozone and Japan and the mistrust of the investors are increasing the demand for US treasury bonds.

Naturally, and following Alfred Marshall’s law (Demand and Supply), the prices of the bonds are increasing and consequently the yields are decreasing in the same proportion, contributing for the inversion of this curve.

Counterarguments

Nonetheless, it is important to mention that there are also positive signs within the economy that might, at least for a while, dispel the recession. These signs include the fact that the low bond yields are widely explained by the aggressive monetary policy stimulus, that might distort a little bit the effectiveness of its predictions. Also, in the yield curve “field”, its small amplitude when compared with the likes of mid 70’s and early 80’s in terms of percentage, until a certain extent reduces the urgency of the warning.

The fact that the S&P 500 is just a few points below July all-time high,which signals goods expectations among the investors in what concerns corporate earnings.

Lastly, and perhaps one of the most important indicators, the fact that wages are growing strongly and the spectrum of deflation, characterized by a general decrease in the prices of goods and services with its implications in terms of wages, is for now a distant reality. This is of huge importance for the US, given that their economy is based 70% on consumption. (Wages grew 4.7 percent annualized in the second quarter of the year, US poverty rate has fallen to its lowest level since before the last financial crisis and Bloomberg Consumer Comfort index that assesses buying climate and personal finances reached an 18 year high, motivated by the good atmosphere that surrounds both the job and equity markets, with its value being fixed in 67.4 by 14th July.)

Conclusion

The past and the economic background that comes with it tell us that the inversion of the yield curve should be considered a serious foreshadowing of a recession, although the current economic atmosphere might have until some extent distorted the trustworthiness of this predictions. It is also important to state that a recession is not necessarily dreadful or horrific, it is indeed natural and takes part in all economic cycles.

However, alongside with continuous decreases in interest rates, trade wars, China’s growth deceleration, wealth and income inequality and others, a recession can be indeed “horrific” and “dreadful”, since it might trigger a more serious economic and political crisis, posing important challenges to government policies, that each day are getting more exposed with the decreasing power of one of its major mechanisms, the monetary policy.

On the 12th of September, the European Central Bank (ECB) decided, after three years of unchanged monetary policy, to cut the interest rate on deposits to -0.5% and to restart, although with small dimension, Quantitative Easing in November with purchases of 20 billion euros of bonds. At the end of his mandate, Mario Draghi, the ECB president, does a last attempt to fulfill the ECB objective: price stability. In this article, on the one hand, we explain how these two measures will fulfil the ECB’s goal and, on the other hand, possible outcomes for the European economy.

An expansion for the last 10 years

The objective of the Central Bank is, indeed, to ensure price stability, that materializes in having the inflation rate below, but close, to 2%. Since the creation of the ECB, and up until the Great Recession of 2008, this goal was achieved, with some minor exceptions. However, since this major event, the achievement of this goal has been more problematic; in particular, in the last 7 years, the inflation rate was consistently below the target, with some years registering a negative inflation rate (meaning prices were falling). Furthermore, looking to the last year, we observe a fall in the inflation rate.

A Central Bank, and in particular the ECB, has several instruments to execute monetary policy. The conventional ones are the interest rate on the main refinancing operations (MRO), which provides the bulk of liquidity to the banking system; the rate on the deposit facility, which banks may use to make overnight deposits with the Eurosystem, and the rate on the marginal lending facility, which offers overnight credit to banks from the Eurosystem. Besides that, the ECB also has unconventional instruments, from which the most famous is the Quantitative Easing programme that consists in the Central Bank buying government securities from the market, thus increasing the money supply, as an attempt to “directly” inject liquidity into the economy, thus encouraging lending and investment. This is an efficient alternative when short- term interest rates approach zero, and open market operations lose their effectiveness. During the last decade, the ECB has been decreasing their interest rates persistently and it was in 2014 that the deposit facility interest rate became negative for the first time.

In fact, Mario Draghi’s popular speech in 2012, when he said that he would do “whatever it takes” to battle deflation, has been the perfect representation of the dovish behaviour of the Central Bank.

This conduct has prevented economic slowdowns in the recent years and, again, it is being used right down to prevent the recession that is expected by the markets in the future, although this is out of the scope of the ECB, the latter being the major difference between the European Central Bank and the North American Federal Reserve.

Euro Zone Inflation rate (HCPI) and GDP real growth rate

The implications of an Expansive Monetary Policy

However, there is a lot of controversy around the stimulus presented by the ECB. On the one hand, by decreasing even more the deposit interest rate, the ECB discourages banks to deposit their money in the Central Bank and, therefore, encourages them to lend it to their customers more easily or to invest it in financial markets. In fact, it is important to have larger amounts of currency in circulation, since this way, households will spend more because they feel wealthier and investors will have more funds to allocate in their portfolios. In other words, the goal is to stimulate consumption and investment and, hence, economic growth.

Moreover, the banks themselves also have greater incentives to invest their surplus (this is, the amount of money they have besides the minimum reserves stipulated by the ECB) since, with negative deposit rates at the Central Bank, investments in financial instruments that are considered nearly as safe as deposits (for example, German bunds) yield a better return, and thus are seen as better investment opportunities. In this way, also the financial markets are stimulated and there are more flows of capital for investment. With the purchase of assets through QE, the ECB can, effectively, when the financial system is under stress and risk premia are high, raise prices of assets, reducing their yields. Consequently, governments have more incentives to increase public investment. This is, indeed, a concern of the ECB, as it has been demanding, from national governments, more fiscal stimulus.

Problems of a long-lasting monetary policy

There are also several problems associated not only with negative rates, but also with the asset-purchase program. Given that rates are at historic lows, each additional stimulus will have to be reduced and, therefore, the effect will not be sustainable enough to provide economic growth; instead, may have adverse effects on fragile banks of the Eurosystem, taking into account that banks are forced to reduce interest rates on deposits for their customers and, as such, suffer great reductions in their profits. Furthermore, the ECB already has 25% of the bonds issued by Eurozone governments, which means that the values of these assets are superficially higher and as such, the balance of the assets of euro area banks does not reflect their true value, which at the end of the QE program will cause major problems for banks. Something to also keep in mind is the risk of being at the famous “zero lower bound” (also known as “liquidity trap”) when the next recession hits. If the interest rates set by the ECB are still this low when the European Economies start really slowing down, the monetary policy will have no room to stimulate the economies and have them grow again. In an era where the southern European countries are still plagued by the large debt levels from the aftermath of the Great Recession, and thus have limited capacity to conduct expansionary fiscal policies, stimulating methods could very well be running short.

Finally, another problem underlying the ECB’s policy is that this is not a normal central bank, but a central bank that serves a confederation of countries and, as such, is subject to conflict of interests from each part in their decision process. In recent years, it has been evident a big difference between the northern countries (such as Germany and the Netherlands), who do not want more stimulus since their inflation figures are above the Euro-area average levels and not so far from the 2%; and the countries of the south, such as Spain and Italy, facing situations of political instability and inflation figures close to zero and needing that extra help to see their economic output grow. As such, the President of the ECB must consider a wide range of realities and, consequently, the decision process results in delays and half measures and the effect is not as substantial and immediate as it should. One example is that this announcement lead to the decrease of more than 20 basis points of the Italy’s 10 years bond yield.

Where will policy be heading next

Currently, it seems that there is no reason for worries and no need to anxiously implement stimulus in the economy since, although economic activity has weakened in recent quarters, it is still much better than in March 2015, when the ECB introduced the QE program. Headline and core inflation are also at higher values as well as inflation expectations from customers. As said by the Dutch central bank chief Klaas Knot, “the only observation [about the Euro Area economy] is currently that the inflation outlook lags behind the ECB’s aim”. However, there are, undeniably, some international threats as such the trade war which may affect some sectors of activity (mainly, manufacturers) in the euro system economies; Brexit, whose future is still very uncertain and entails mistrust for firms and investors; and, among others, political instability in Italy. Hence,

European countries will go through unknown paths in the next months and the future of the economy is quite unpredictable nowadays.

This is why Mario Draghi decided to bring back in the end of his mandate the monetary weapons, that allowed him to win some battles in the past and called governments to action by saying that monetary policy alone is not enough and fiscal policies are also important to keep economies moving in the right way.

Tiago Bernardino Diogo Costa