Co-Head of Global Bonds Nick Maroutsos gives the US Federal Reserve high marks for ensuring properly functioning financial markets but believes that work still needs to be done to support households and small businesses most vulnerable to the economic disruptions caused by the COVID-19 pandemic.
- The US Federal Reserve (Fed) announcement on 10 June 2020 offered little that is new given that the central bank had already committed itself to highly accommodative policy well into the foreseeable future.
- We believe the Fed must do a better job in channelling support towards vulnerable households and small businesses given that the low rates extended to large corporate borrowers may only minimally permeate through the broader economy.
- The disconnect between signals emanating from stocks and bonds is proving worrisome as equities are pricing in a recovery while bonds flash low growth and disinflation; such a contrast creates difficult decisions for investors in guessing which scenario is correct.
The decision by the Fed to stay the course on interest rates was largely a non event as the central bank had already telegraphed its intentions for the foreseeable future. This was illustrated in the median forecast for the fed funds target rate in its dot plot survey to hold steady through 2022. While we agree that the Fed deserves high marks for the speed and magnitude with which it acted as the COVID-19 pandemic shuttered the global economy, we believe that there are several pertinent issues the central bank still must address.
A tale of two economies: not again
Fed chairman Jerome Powell’s unvarnished comments painted a picture of a suffering economy. There is little to celebrate in an economy that contracted at a 5% annualised clip during the first quarter and posted a double digit unemployment rate.1 This brings up the first disconnect that the Fed must address. We find it hard to reconcile large cap US equity indices at or near record highs while data from the real economy remain grim. The natural conclusion, unfortunately, is the re emergence of the disconnect between the fortunes of Wall Street and those of Main Street.
Since late March, riskier assets have rallied considerably as the one two punch of fiscal and monetary stimulus have given investors hope that the size of these programmes will be sufficient to plug the gaping hole in the US economy caused by a historic drop in consumption and business investment. But while stocks and corporate credits have benefited from easier financial conditions, the programmes directed towards Main Street have encountered a range of fits and starts. Paycheck protection does not appear to meet the scale of the wages lost and the flow of credit to small and medium businesses has been slow and strewn with pitfalls.
These setbacks harken back to the years following the Global Financial Crisis, when loose financial conditions benefited holders of financial assets, while workers faced years of stagnant real wage growth. The Fed has rightfully addressed this inequality, but now it must prove it is capable of channelling help to where it is most needed. Given the role both small businesses and personal consumption play in the US economy, we believe Main Street needs to be placed ahead of Wall Street. So far, that has not been the case.
Another disconnect that the Fed must address are the cross currents emanating from stock and bond markets. Equities have priced in what we view as a ‘better case’ scenario. We are more cautious. The surprise May jobs report was a single point in time, and lest we forget, there still is no vaccine for COVID-19, which puts the global economy at risk of the much feared second wave. Again, it is difficult to imagine earnings bouncing back considerably when so much of US corporate revenues are directly or indirectly tied to the health of household finances.
Bonds, on the other hand, are pricing in a more sombre environment. While we recognise that the Fed has its hands on the scale in favour of low rates, the breadth of the dissonance between what stocks and bonds are signalling is something the Fed should seek to minimise. It bears remembering that stockholders only get paid if bondholders are made whole, and if the latter market is signalling lower growth and – should a second wave hit – a possible rise in delinquencies, we will treat the formidable rally in the former with suspicion.
Inflation: a pass – for now
We believe the Fed can get away with keeping rates on hold into 2022 because inflation remains scant. Yes, there may be a near term uptick in supply side disruptions and the release of pent up demand but evidence from other countries shows that the longer term disinflationary trends ultimately trump highly accommodative monetary policy.
Next stop: yield curve control
While this meeting may have been a non event, we believe the September conclave will be of greater substance as the Fed is more likely to broach the subject of yield curve control. We believe this is a matter of ‘when’, not ‘if’. However, based on other countries’ experiences, we expect any benefits from instituting such a programme would be minimal. Talk of taking rates negative will also seep into the conversation, but we consider this scenario unlikely as its results are even more questionable than yield curve control. Just ask Europe and Japan.
That said, we do believe there will be upsizing and tweaks made to existing programmes, especially those targeting Main Street. Until the Fed instils the same level of confidence in small businesses and wage earners that it has for the larger corporate borrowers feasting on low rates — without seeing those benefits permeate into other pockets of the economy — we believe the prospects for a full recovery remain tenuous.
1Source: Bureau of Economic Analysis, US gross domestic product Q1 2020, second estimate at 28 May 2020; US Bureau of Labour Statistics, US unemployment rate (13.3%) in May 2020, release of 5 June 2020.