Markets: The next rate hike won't be in June
Last Friday's US jobs data were uninspiring. Only 38,000 jobs were added in May after a poor showing in April as well. Strikes in the telecoms sector (idling 35,000 workers) and a decline in temporary help services (-21,000) weighed heavily. The figures fell short of the 100,000 jobs that have to be added to absorb new entrants into the labour market.
The concomitant dip in the unemployment rate to 4.7% offers only cold comfort, as it was the result of a decline in the working population.
Before we start worrying, we need to wait and see whether the May figures were a blip or the start of a new trend. One factor to keep in mind is that, once full employment was reached, we expected job creation to slow to around 100,000 per month. The markets may be thinking the same thing, since they rebounded before the day was out.
United States: The Fed's focus on financial conditions
The US Federal Reserve (Fed) has been looking hard at the economy's financial conditions over the past few quarters. This catch-all term refers to a number of factors that help determine economic behaviour and the future course of the economy, such as the state of the markets, yield spreads, the yield curve, the dollar and surveys of lending standards. Monetary policy affects each of these factors, as can be seen clearly following the Fed's first rate hike last December when financial conditions tightened markedly.
The Fed responded by dialling down its discourse at the start of the year. And since that time, most of these factors have reversed course: the dollar has stabilised, markets are up and corporate spreads have narrowed.
But one key variable, the yield curve, continues to flatten. Long-term interest rates generally rise when monetary policy enters a tightening phase, yet that is not happening here. There are several reasons for this:
- First, long rates trend upward in this scenario because monetary conditions are generally tightened at the start of an economic cycle. But that is not the case here. The US economy has been growing faster than its potential GDP rate for the past few years, which means that the Fed started to raise rates well into the cycle.
- Surplus liquidity channelled into the markets around the world has driven up demand for US Treasuries and put downward pressure on long-term interest rates in the USA. Two other factors are at play:
- The Fed reinvests in Treasuries in its portfolio as they mature (and has given no indication that it would reduce its balance sheet; see left-hand chart below). With the Fed holding 23% of government debt, these are hefty amounts being reinvested.
- The European Central Bank and the Bank of Japan's unorthodox monetary policy is holding those countries' interest rates down. This makes US debt more attractive and encourages international investors to engage in carry trades targeting US Treasuries.
- Insurance companies, mutual funds and pension funds are another source of demand for Treasuries. These financial institutions, which are contractually obliged to achieve a certain return, have to invest in high quality and highly liquid assets that still offer a positive return. They invest in long-term Treasuries rather than short terms T-bills in pursuit of the higher payoff.
- The government's Treasury debt supply has dropped in recent years. The government is issuing less debt because, with a narrowing budget deficit, its funding needs have declined. The government also tends to meet its funding needs with short-term T-bills rather than long-term Treasuries. All these factors tend to pull long-term interest rates downward.
- The global saving glut is a structural cause of declining long-term rates. With the supply of saving outpacing global investment, the interest rates that link the two have fallen. Unlike in prior decades, however, the lower interest rates have not boosted investment demand.
- Long-term interest rates should remain structurally low given global imbalances and surplus liquidity and savings that will not be absorbed any time soon.
- The Fed, one of whose missions is to stabilise the financial system, will do what it can to make financial conditions less sensitive to monetary policy.
- US growth will benefit from easing financial conditions and persistently low long rates. This will encourage households, which have reduced their debt in recent years, to borrow more and could give a boost to consumer spending and the property market.
- Several caveats are in order:
- This low interest-rate scenario does not mean interest rates will not rise, but that they will rise less quickly than in previous cycles.
- A scenario of robust growth and structurally low long rates can lead to financial bubbles and wide market swings. Something to keep in mind.