Monday Digest
Posted 23 September 2024
Central bank pivot 2.0
The US Federal Reserve’s 50 basis point interest rate cut was last week’s biggest story, and markets took it well. It was portrayed as a surprisingly large cut, but markets had already priced in a high chance of a big cut. Markets also predicted the Bank of England holding rates steady, but are now confident of a November cut to UK rates. The trajectory is down on both sides of the Atlantic – but the implied pace of cuts is notably quicker in the US.
That might seem strange, given the US’ continued outperformance. But US wage inflation is now falling quicker than elsewhere, and Fed chair Powell said the 50bps cut was a ‘catch up’ – making up for not cutting last time – rather than an omen. Markets agreed, and are again confident that the Fed has pulled off a ‘soft landing’ (lower rates without recession). We doubt that the decline in rates will be as quick or as smooth as markets are currently predicting, though. True the Fed is more worried than other central banks about unemployment, but recent data has been better and rate cuts (both actual and expected) will themselves support the economy. Lower mortgage rates are already encouraging builders, for example.
Markets seem as overconfident about rate cuts as they were for ‘Pivot 1.0’ last year. Bond yields could therefore rise from here. While that could hamper stock valuation metrics, it should also mean higher profit growth – not a bad balance for risk assets.
Less positive was the People’s Bank of China (PBoC) unexpectedly holding rates high, despite clear economic weakness. Markets thought a big Fed cut would give the PBoC room to loosen policy, but it is keeping financial conditions incredibly tight – with historically weak money supply growth. Beijing clearly has a tightening bias and is willing to let domestic demand suffer in response. That means China will keep exporting disinflation – which is good for keeping global inflation down, but bad for supporting global growth. We will have to watch China’s policy developments closely, given its fraught political history.
Oil fragmentation and its impact on Saudi Arabia
Saudi Arabia is the world’s biggest oil exporter and the de facto head of the OPEC price cartel, but market fragmentation is challenging its global dominance. The creation of OPEC+ (with 10 additional nations including Russia) strengthened the bloc’s ability to manage global prices, but the US has now become the world’s largest oil producer, and there is increased competition from non-traditional producers like Brazil, Angola and Nigeria.
Sanctions on Russia and Iran have also redirected – rather than removed – oil flows. China is now a critical market for Saudi oil (the Kingdom accounts for 15% of China’s oil imports) but its economy is weak and it increasingly buys discounted Russian or Iranian oil.
The world needs to transition away from oil over the long-term, which is why Saudi Arabia is pursuing an ambitious economic restructuring plan called Vision 2030 – with investments estimated to be worth $1.25tn. But the plan’s success depends on current oil revenues, which are under pressure. The IMF estimates that Saudi Arabia needs $96.20 per barrel to breakeven with fiscal expenses, well above the current price.
If the Kingdom pressured OPEC+ to collectively cut production or tries to regain market share by flooding supply at lower prices – as it has done in the past – that would worsen its fiscal deficit and endanger its long-term structural investments. A global growth rebound would help, but the US economy is slowing and Chinese demand has been weak for a long time. Saudi Arabia’s two biggest challenges pull it in opposite directions: market fragmentation calls for oversupply to regain market share; the green transition calls for undersupply to inflate current prices. Fiscal challenges might force the Kingdom to increase supply regardless.
Insight: Yield Curve Un-invertigo
The US yield curve is a plot of government bond yields across different maturities. Finance people call it ‘normal’ when it slopes upwards – since bond holders generally want higher fixed interest if fixing their coupon income over the longer-term – and ‘inverted’ when short-term yields are higher than long-term. A common definition calls it inverted when 2-year treasury yields are higher than 10-year yields, and on that basis it was inverted from July 2022 until the start of September. Since then, it has “un-inverted”.
This is significant because an inverted yield curve is an historically reliable recession predictor – since it suggests returns (i.e. growth) will be lower in the future. But un-inversion unfortunately doesn’t indicate no recession. For starters, the common 10-2 definition is rather arbitrary, and the yield curve is still inverted if you use 3-month yields as a starting point rather than 2-years. Moreover, the yield curve often un-inverts (on the 10-2 definition) just before a recession. That’s why some analysts have sounded the alarm over the recent un-inversion (along with some employment-based recession indicators).
We don’t think a US recession is imminent, however. There are well-known problems with using the yield curve as an indicator at the moment – mostly centred around the distorting effects of central banks’ bond-buying (and now selling) programmes. The yield curve certainly tells us that short-term interest rates will fall sharply in the next two years, but that itself should support growth. It’s a sign that investors expect a ‘soft landing’ (rates falling and growth re-accelerating without a recession in between). But the yield curve’s relatively shallow incline (past two years) also suggests a lack of confidence in long-term growth. This fits with what a host of indicators are telling us, and it points to decent – but perhaps underwhelming – returns in the months ahead.