How our low inflation world was made

The picture is one of weak growth and pervasive populist politics

Martin Wolf



If we are to make sense of where the world economy is today and might be tomorrow, we need a story about how we got here. By “here”, I mean today’s world of ultra-low real and nominal interest rates, populist politics and hostility to the global market economy. The best story is one about the interaction between real demand and the ups and then downs of global credit. Crucially, this story is not over.

Amazingly, prior to 2009, the Bank of England never lent to banks at a short-term rate below 2 per cent. That had been low enough to cope with the Napoleonic wars, two world wars and the Depression. Yet, for a decade its rate has been close to zero. The bank has been in good company. The US Federal Reserve has managed to raise its federal funds rate to 2.5 per cent, but only with difficulty. The European Central Bank’s rate is still near zero, as is the Bank of Japan’s. The latter’s rate has been close to zero since 1995. Yet the BoJ has still been unable to get inflation much above zero. Weak inflation is not Japan’s problem alone. It remains strikingly low elsewhere, too. (See charts.)

In fact, we should not be that surprised by this world of persistently weak inflation and ultra-aggressive monetary policies, including outright asset purchases by central banks and favourable long-term lending to banks. Ray Dalio of Bridgewater has laid out the logic in his important recent book Principles for Navigating Big Debt Crises. The central point is that governments of countries whose debts are denominated in their own currencies can manage the aftermath of a crisis caused by excessive credit. Above all, they can spread out the adjustment over years, thereby preventing a huge depression caused by a downward spiral of mass bankruptcy and collapsing demand. Mr Dalio calls this a “beautiful deleveraging”. It is achieved by a mixture of four elements: austerity; debt restructuring and outright default; money “printing” by central banks, not least to sustain asset prices; and other transfers of income and wealth. An important element in this deleveraging is keeping long-term interest rates below growth of nominal incomes. That has in fact been done, even for Italy.

US policymakers were the most successful in reacting comprehensively. In the 1990s, Japan took too long to adopt the right combination. So did the eurozone after 2008, largely because of obstacles to active fiscal policy in such a currency union, but also because of ideological resistance to using the full capacities of the central bank. The UK’s response fell between that of the US, on the one hand, and of Japan and the eurozone, on the other.




Even if the needed policies are successfully adopted, they are always unpopular. So, not least, is the aftermath of any financial crisis. Sharing out losses generated by a financial crisis, followed by the inevitably weak recovery, always creates public rage.

Where has this left us today? Not where we would like to be, is the answer, in three respects.

First, while financial and household debt have fallen relative to incomes in mature economies, that is not true for debts of governments or non-financial corporates. Second, the transatlantic crisis triggered offsetting debt explosions elsewhere, notably in China. Third, crisis-hit economies are still far below pre-crisis trend output levels, while productivity growth is also generally low. Finally, the populist politics of left and right remain in full force. All this is in keeping with past experiences with big debt crises, which have always thrown long shadows into the future.



So what might happen next? To answer, we need to consider not only the now familiar post-crisis world but also what came before. Crucially, the world of falling real interest rates on safe assets preceded the crisis. Larry Summers has described that phenomenon as “secular stagnation” — that is, a world of structurally weak aggregate demand. A decisive moment was the Asian financial crisis, after which the world’s most dynamic economies became net exporters of capital.

But there are other significant factors: high gross savings rates in important emerging economies; persistently weak productivity growth in high-income economies; ageing in many economies and so a declining demand for physical capital; and deindustrialisation in high-income economies. Also important have been rapid falls in the relative prices of capital goods and shifts in the distribution of income towards profits and the highly paid. The overall effect has been to shift the balance between potential income and desired spending, against the latter. The result has been falling real interest rates.




Even the financial crisis was the result of this environment. Low (nominal and real) interest rates triggered rising property prices and an associated credit explosion, especially in the US and peripheral Europe. These credit bubbles drove demand worldwide in the early 2000s. They proved unsustainable, so bequeathing the post-crisis world we have lived in since 2008. But that world has not ended. The interest rates we see today demonstrate that.




We can divide the last two decades into two periods. “Pre-crisis secular stagnation” was a world characterised by low and falling real interest rates and hugely destabilising property and credit bubbles. “Post-crisis secular stagnation” has been a world of near-zero real interest rates, partial deleveraging, weak growth and pervasive populist politics.



So what might the next period look like? Will the world economy escape into something less unstable? Or are we risking disruptions from renewed debt crises and political instability. And what, not least, are the best policy options, in response? I plan to address these questions next week.



Will you still feed me?

Chile tinkers with its ground-breaking pensions system

Under the current system, those who don’t save get very Little



ACCORDING TO José Piñera, its mastermind, Chile’s pension system is a “Mercedes-Benz” system. Introduced in 1981 under the dictatorship of Augusto Pinochet, it replaced a pay-as-you-go system of funding pensions (where current workers pay for current retirees) with one where people are required to save a portion of their salaries for their own pensions, and their contributions are invested in private funds. The model was one of the first to try to make public pensions sustainable. But its future is far from certain.

Last month José’s brother, Sebastián Piñera, Chile’s centre-right president, persuaded congress to debate plans to reform the system, despite not having a majority. The 14 opposition deputies who broke ranks and voted in favour of discussing the government’s bill were branded “traitors” by many on the left, who want to bring back a redistributive pay-as-you-go system.

By many measures the system has been a success. Today private pension funds manage around $212bn, equivalent to 75% of Chile’s annual GDP. That capital has helped to fuel Chile’s economic boom, which has made the country the richest in South America. The trouble is that the payouts have not lived up to many Chileans’ inflated expectations.

People were told they would get pensions worth 70% of their final salary if they chipped in 10% of their earnings for 37 years. But on average, Chilean workers contribute for less than half of their working lives, says Fernando Larraín of the fund managers’ association. Around 30% of employed Chileans work informally. If paid in cash, they seldom put any of it in a pension pot. Others are unemployed, studying or raising children. As lifespans lengthen, the money they save will have to stretch further. Projections by the OECD suggest that the average Chilean earner will get less than 40% of their final salary in old age.

Attempts have been made to add a safety-net. In 2008 a centre-left government introduced a tax-funded basic pension, now worth $154 a month to 600,000 elderly people who had no savings. A subsidy tops up the pensions of another 900,000. Together they now cover over half of Chile’s 2.8m retirees. “We now have a mixed system,” says David Bravo of the Catholic University.

But many Chileans want more redistribution. Mass protests have taken place every year since 2016, most recently in March, excoriating the companies that manage the pension pots. Returns have actually been rather good—funds have made 8% per year since the 1980s—but protesters complain that managers have taken too big a cut (administration costs 1.25% of salaries).

Mr Piñera’s plan would require employers to contribute, with the money going into a new state-run fund. It would also give incentives to postpone retirement. But it does not raise the retirement age. Nor can pension reform ever solve the deep inequality that lies behind the anger. Half of Chileans earn less than $550 a month. “It’s a ticking bomb,” says Marta Lagos, the co-founder of MORI-Chile, a pollster.

How the Failure of “Prestige Markets” Fuels Populism

Given the requirements of today’s technology, dismissing expertise as privilege is dangerous. That's why a well-functioning prestige market is essential to reconciling technological progress and the maintenance of a healthy polity.

Ricardo Hausmann

hausmann73_Brooks Kraft LLCCorbis via Getty Images_harvardbuilding


CAMBRIDGE – One of the slogans of the Harvard Union of Clerical and Technical Workers is, “We can’t eat prestige.” In other words, the university should not get away with paying low wages just because it is prestigious to work there.

But while prestige may not be nourishing, it is sustaining. In fact, the logic behind prestige, and its relation to technology and to people’s identity, may have everything to do with the rise of populism and with the perils of populist policies.

Prestige is in our genes. According to biological anthropologist Joseph Henrich, it evolved because we are a cultural species, in the sense that our individual survival depends on acquiring the knowledge that resides in the collective brain. We acquire it through imitation, but we need to decide whom to imitate. Numerous scientific studies have shown that we tend to imitate people who are perceived to have prestige, a sense that develops very early in childhood.

Henrich suggests that this is the outcome of an evolutionary game in which prestige is payment for the generosity with which the prestigious share their knowledge. We share alpha-male dominance with our primate cousins, but prestige – a form of “payment” that predates money, wages, and stock options – is quintessentially human.

While prestige solved a problem that has been with us throughout our evolution, it has had to interact with the technological changes of the past half-century. In particular, the rise of what economists call skill-biased technical change – the reliance of modern technologies on highly skilled workers – has led to growing wage differentials between skill levels.

In his new book The Future of Capitalism, Paul Collier argues that this increased wage inequality has changed the self-perception of the highly skilled: their professional identity has gained greater salience than their sense of themselves mainly as members of the nation. Using a model of human behavior proposed by George Akerlof and Rachel Kranton, Collier argues persuasively that the satisfaction conferred by one identity relative to another – say, the profession over the nation – depends on the esteem with which others regard that identity.

As wage differentials grew, and the highly skilled shifted the focus of their identity from nationhood to profession, the value for all others of maintaining their national identity decreased. The low-skilled were trapped in a less valuable national identity.

This dynamic, according to Collier, explains the vote for Brexit in Britain and the rise in right-wing nationalism in other rich countries: it is concentrated among lower-skilled inhabitants of more rural, less ethnically mixed environments where traditional national identity is still dominant. It also explains declining trust in elites: because members of the elite identify primarily with their more global professional identity, they are perceived as caring less about their reciprocal obligations with the rest of the nation. Delegating choices to experts is passé, because experts no longer care about the rest of us.

Rising wage differentials may destroy the equilibrium proposed by Henrich. If the prestigious are already very well paid, and are not perceived as being generous with their knowledge, prestige may collapse. This may be another instance of the incompatibility between homo economicus and community morality emphasized by Samuel Bowles in his book The Moral Economy: the self-interested, transactional behavior that defines the market is not acceptable in the family or the community.

The collapse in the prestige equilibrium can do enormous damage to a society, because it may break the implicit contract whereby society uses critical skills. To see why and how, look no further than what has happened in Venezuela.

In 2002, then-President Hugo Chávez’s left-wing populist rhetoric targeted the national oil company PDVSA. The company was already a state-owned enterprise, so nationalization was not the issue. For Chávez, the problem was PDVSA’s meritocratic culture: to succeed in the company, political connections were of no use. What the company valued most was the knowledge needed to manage a complex organization.

Social barriers to entry at PDVSA were low, because Venezuela had a 50-year history of free university education and decades of generous scholarships to study abroad, especially in oil-related fields. But once in, advancement was merit-based. A similar culture developed in the power sector, the central bank, universities, and other entities that were critical for state capacity.

The populist revolt equated knowledge with privilege and threw it out the window. When the merit culture was threatened, the company went on strike, and more than 18,000 workers – over 40% of the company’s labor force and almost all of its senior management – were fired. As a result, there was a spectacular collapse in the performance of the oil industry and, eventually, in all the other institutions affected by the war on expertise, leading to the catastrophe that is Venezuela today.

The lesson is clear. Given the requirements of today’s technology, dismissing expertise as privilege is dangerous. But because gaining expertise takes time and effort, it is not freely accessible to “the people.” The only way to sustain it is through an implicit prestige market: the experts are supposed to be generous with their knowledge and committed to the nation. Society “pays” them back by according them a social status that makes their position desirable, even if wage differentials are compressed, as they often are in the public sector (and were in Venezuela at the time of the lethal attacks on expertise).

The alternative to populism is an arrangement whereby experts demonstrate authentic public spiritedness in exchange for society’s esteem, as often happens with military leaders, academics, and doctors. A well-functioning prestige market is essential to reconciling technological progress and the maintenance of a healthy polity.


Ricardo Hausmann, a former minister of planning of Venezuela and former Chief Economist of the Inter-American Development Bank, is Director of the Center for International Development at Harvard University and a professor of economics at the Harvard Kennedy School. He has recently been appointed as Governor of Venezuela at the Inter-American Development Bank by Interim President Juan Guaidó.

Why Erdogan Can’t Give Up on Istanbul

The local mayoral race will be re-held, but time isn’t on the president’s side.

By Xander Snyder


 
Despite winning a favorable ruling from the country’s electoral authority, the pressure seems to be mounting on Turkey’s ruling party. On Monday, Turkey’s High Election Council canceled the results of Istanbul’s March 31 mayoral election, which a candidate from the opposition Republican People’s Party had won by a narrow margin. Initially, President Recep Tayyip Erdogan said he and his Justice and Development Party, or AKP, would accept the results of the election. But they quickly changed their minds and challenged the results, claiming voting irregularities, including that individuals with links to cleric Fethullah Gulen, whom Erdogan blames for planning the 2016 coup attempt, had nullified the ballots of up to 15,000 voters. The electoral authority has ordered that the election be rerun on June 23.

Following the announcement, Turkey’s lira plunged in value, falling to 6.16 liras to the dollar on Tuesday, its lowest point since October 2018. Currency pairs tend to move on even the slightest bit of good or bad news, so one could easily draw the conclusion that the falling lira is a result of the election controversy. But the fundamentals of the Turkish economy that make the lira vulnerable in the first place – namely, high external debt and low foreign reserves – have remained relatively unchanged for a while.




For the most part, Turkey’s economy has performed fairly well under the AKP’s watch. But the country’s relatively high growth rates in recent years have been fueled by debt, much of which was borrowed abroad because of the lack of domestic investment capital. Foreign currency-denominated debt is risky because, if the value of the domestic currency falls, foreign debt becomes costlier to pay off. In such scenarios, foreign currency reserves become very important; they can be used to service foreign debt and avoid using the weaker national currency, making debt payments relatively less expensive.




Turkey, however, has not been particularly good at accruing and holding on to foreign reserves. Turkey’s gross foreign reserve assets (excluding gold) have declined over the past five years from a peak of around $110 billion to about $73 billion in late April. But Turkey’s net foreign reserves are only roughly $26 billion. Even this figure, however, is somewhat inflated. In late March, to avoid a potential selloff of the lira in the run-up to municipal elections, Turkey started borrowing foreign currency using dollar-lira swaps. Essentially, Turkey’s central bank’s swap facility provided more liras to investors in exchange for dollars, which, on paper, made Turkey’s net reserves position appear better than it actually was. The problem, of course, is that Turkey doesn’t actually own those dollars – they are just on loan. Taking this into account, Turkey’s actual net reserves are closer to $11 billion. In 2018, Turkey’s imports totaled approximately $223 billion, or $19 billion per month on average, which means its net reserves could cover less than one month’s worth of imports.





Turkey’s central bank has argued that gross reserves, rather than net reserves, are a better indicator of capital adequacy – the minimum amount of reserves a country needs to have on hand – because there’s no generally accepted rule for what liabilities net figures should account for. Considering Turkey’s total external debt burden was roughly $448 billion at the end of 2018, its gross reserves cover about 16 percent of its total external debt. If you factor in Turkey’s approximately $20 billion in gold reserves, the coverage ratio rises to nearly 21 percent. But it plummets to just 2.5 percent when calculated using net reserves, excluding the short-term borrowed dollars. Should Turkey need to buy liras to prop up the currency, its coverage ratio would decline even further.

Now Turkey is stuck with a menu of bad options to try to solve its economic problems. One option is to continue with the prior policy – keep interest rates as low as possible and access to credit plentiful. Cheap credit helped fuel Turkey’s economy in the past, so it could potentially help keep growth rates up while the government kicks the can of foreign debt down the road.

However, Turkey’s economy contracted in the third and fourth quarters of 2018, and its inflation reached nearly 20 percent in April, indicating that the country may no longer be able to hold off the negative consequences of debt-fueled growth. The second option is to raise rates and attempt to generate organic growth that’s not dependent on foreign borrowing.

Both of these paths carry political consequences. Continuing on the current path could mean higher inflation, which would increase the cost of living and could motivate people to turn away from the AKP. Attempting to fix Turkey’s structural economic problems – in part by raising rates, encouraging greater domestic savings and accumulating more domestic capital with which to lend – would probably prolong Turkey’s economic slowdown and create serious economic pain for many average Turks. Both options could hurt the AKP’s popularity ratings, but the party doesn’t appear to have any better alternatives other than simply managing the fallout from the crisis, which isn’t a particularly inspiring political platform.

The AKP is clearly aware that its management of Turkey’s economic problems could threaten its hold on political power. If the AKP felt secure politically, then losing a local election wouldn’t be a major concern. But knowing that things will only get harder as time goes on, it has to take each vote seriously. Pushing for a rerun of the Istanbul elections, therefore, is, more than anything, an admission that time is not on the AKP’s side.



Xander Snyder is an analyst at Geopolitical Futures. He has a diverse theoretical and practical background in economics, finance and entrepreneurship. As an investment banker, Mr. Snyder worked in corporate debt origination and later in a consumer-retail industry group at Guggenheim Securities, participating in transactions ranging from mergers and acquisitions, equity and debt capital raises, spin-offs and split-offs to principal investing and fairness opinions. He has worked on more than $4 billion worth of transactions. He subsequently co-founded and served as CFO for Persistent Efficiency, an energy efficiency company that used cutting-edge technology to create a new type of electricity sensor for circuit breakers and related data services. In his role, he was responsible for raising more than $1.5 million in seed capital and presented to some 70 venture capital and angel investors in the process. He also signed four Fortune 500 companies as customers, managed all aspects of company accounting, budgeting and cash flow, investor relations, and supply chain and inventory management. In addition to setting corporate strategy, he helped grow the company from two people to a 12-person team. As an independent financial consultant, Mr. Snyder wrote an economics publication for a financial firm that went out to more than 10,000 individuals and assisted in deal sourcing for a real estate private equity fund. He is an active real estate investor and an occasional angel investor. Mr. Snyder received his bachelor’s degree, summa cum laude, in economics and classical music composition from Cornell University.

The U.S. Can’t Escape the Middle East

The latest deployment of forces to deter Iran shows the Pentagon’s challenge in shifting resources toward Russia and China.

By Lara Seligman

The Nimitz-class aircraft carrier USS Abraham Lincoln sails with the Abraham Lincoln and John C. Stennis carrier strike groups as they conduct carrier strike force operations in the U.S. 6th fleet.
The Nimitz-class aircraft carrier USS Abraham Lincoln sails with the Abraham Lincoln and John C. Stennis carrier strike groups as they conduct carrier strike force operations in the U.S. 6th fleet. U.S. Navy photo by Mass Communication 3rd Class Jeff Sherman/Released


Almost 16 months ago, then-U.S. Defense Secretary James Mattis initiated a course correction for the Pentagon. After 17 years of war in the Middle East, great power competition with Russia and China, not terrorism, would be the priority.

But this week, the White House ordered an aircraft carrier strike group operating in the Mediterranean Sea and bomber task force to move to the U.S. Central Command region, in a striking show of force designed to counter what acting Defense Secretary Patrick Shanahan called “a credible threat” from Iran to attack U.S. forces. Days later, Secretary of State Mike Pompeo canceled a planned trip to Germany to make an unscheduled stop in Iraq to discuss the tensions with Tehran. Now, the United States is reportedly considering sending additional bomber aircraft and moving some Patriot missile batteries back to the región. 
The unusual movement of U.S. military forces, which was announced by Iran hawk John Bolton, the national security advisor, reflects the challenge the Pentagon faces in shifting focus to preparing for the next war while it is still mired in the current fight.
“Despite all of the administration’s attempts to reduce the U.S. footprint in the Middle East, the latest move illustrates how difficult it is for the U.S. to extricate itself from the region and free up resources to focus on Russia and China,” said Becca Wasser, a policy analyst at the Rand Corp.


The continued focus on Iran despite the department’s stated pivot to Russia and China has frustrated many observers and former officials. Wasser pointed out that the Defense Department ranks Iran as a fourth-tier threat in the 2018 National Defense Strategy, the Pentagon’s latest guiding document.

“It’s this alternative universe where Iran is an equivalent threat [to Russia and China],” said one former defense official. “They are messing around in the Middle East and all over the place, but hammer, nail? It’s more like hammer, apple.”

The former official expressed hope that once Shanahan is confirmed as permanent secretary of defense, the balance will shift back to great power competition.

At the Pentagon this week, details about the deployment trickled out in fits and starts. Shanahan, who on his second day on the job back in January said China was his top priority, finally issued a statement on the move almost a full day after the White House first announced it.

“We call on the Iranian regime to cease all provocation,” Shanahan said. “We will hold the Iranian regime accountable for any attack on U.S. forces or our interests.”

The decision originated with Gen. Kenneth McKenzie, the newly minted commander of U.S. Central Command, but was left to the White House to announce, according to a defense official. McKenzie requested additional forces in the region following “recent and clear indications that Iranian and Iranian proxy forces were making preparations to possibly attack U.S. forces,” according to Centcom spokesperson Capt. Bill Urban.

The Pentagon received indications of “very, very credible intelligence” on Friday afternoon, Shanahan told lawmakers during a hearing on Wednesday. However, the administration has yet to provide details about that intelligence or where it originated.

McKenzie had been something of a wild card in the latest escalation of tensions between Washington and Tehran. He took the reins of the world’s most volatile region from Gen. Joseph Votel in March, after serving as director of the joint staff at the Pentagon under Mattis since 2017.

But McKenzie made his views clear on Wednesday during a speech in Washington, revealing a hard line on Tehran. He dedicated nearly half of a 30-minute speech to sounding the alarm on Iran on Iran’s “malign” activity and ambition across the globe, noting that Tehran is responsible for the deaths of more than 600 U.S. service members in Iraq and issuing an explicit warning to the regime.

“While we do not seek war, Iran should not confuse our deliberate approach with an unwillingness to act,” McKenzie said of the deployment.

Some expressed skepticism that Bolton’s statement was much more than a symbolic gesture, pointing out that the USS Abraham Lincoln was already embarked on a scheduled deployment to the Mediterranean and had planned to eventually head to Centcom.

But the Pentagon expedited the carrier’s arrival, skipping a planned port visit to Split, Croatia, and ending an unusual “carrier gap,” when the United States had no carrier presence at all in the Persian Gulf.

The deployment of a small bomber task force, too, is a significant move. Although bombers typically rotate seamlessly in and out of the region, the B-1 squadron most recently stationed at Al Udeid Air Base, Qatar, left in March and has not yet been replaced—an unusual shift that many attributed to the defeat of the Islamic State’s physical territory.

A second defense official confirmed that the deployment, which will consist of four aircraft from Barksdale Air Force Base in Louisiana, was not previously planned.

Beyond Iran, Hans Kristensen, the director of the Nuclear Information Project at the Federation of American Scientists, said the task force deployment is a signal to Russia and China about the offensive capability of America’s bomber force. However, he said, “this is clearly overreach and chest thumping resulting from the administration’s obsession with Iran.”

In a recent article for Foreign Policy, Elbridge Colby, who served as deputy assistant secretary of defense for strategy and force development in 2017 and 2018, stressed that preparing for a war with Russia or China does not mean ignoring other threats to America’s interests. It just means the United States must right-size its approach to those threats.

“The United States needs to check Iran’s aspirations for regional hegemony but not overthrow the Islamic Republic,” Colby wrote. “The United States does not need F-22s to attack terrorist havens nor whole brigade combat teams to advise Middle Eastern militaries; cheaper drones and tailored advise-and-assist units will do.”

By that logic, sending an entire carrier strike group and bomber task force to respond to a yet unnamed threat from Iran—especially when U.S. forces in the region often face provocation from the regime and proxy forces—might be overkill.

McKenzie stressed that the deployment is an example of what the military calls “dynamic force employment,” meaning a force that is agile enough to respond rapidly to any contingency around the world. This signals to our allies and adversaries that the United States can “project power where we need it.”

But ultimately, Bolton’s unexpected announcement reflects a setback for the pivot to great power competition, Wasser said.

“It ultimately undermines DOD’s main priority in the NDS—Russia and China—in the grander scheme, as resources and attentions are bogged down in the Middle East,” she said.

Rate Cuts Are Coming

by: The Heisenberg
 
 
Summary

- Friday's disappointing jobs report in the US likely seals the deal for Fed cuts.

- Markets now see Fed easing from July onward, as the latest data is interpreted as "confirmation" that the US economy is finally decelerating.

- With market pricing and Wall Street now "doved-up" to the max, Jerome Powell will need to cut next month, if not sooner.

 
If you wanted to, you could point to news that the US will delay the imposition of higher tariff rates on some Chinese products to June 15 as a catalyst for the Friday morning surge in equities (SPY), but it's probably safe to assume that rate cut bets are again playing a big role in propelling stocks.
 
In the wake of the disappointing May payrolls report (top pane in the visual), the market is priced for cuts starting in July - as in, starting next month.
 
 
(Heisenberg)
 
 
Pressure on Powell to get out ahead of things by, at the very least, signaling imminent easing at the June meeting, is growing. 2-year yields plunged 11bp on Friday morning and are on track for a fifth straight week of declines.
 
Note the chart in the bottom pane of the visual. As the legend indicates, the purple line is the US 2-year yield minus the funds rate. Both Goldman and David Rosenberg referenced that chart this week in suggesting that rate cuts are probably just around the corner.
 
"The 2-year rates minus Fed Fund Rate is now close to -40bp and historically from this level the Fed has usually delivered a cut in the following months," Goldman wrote Monday. "Surely if Jerome Powell is a 'markets guy' he’ll eventually understand that when the 2-year T-note yield drifts more than 50 bps below the funds rate, nasty things tend to happen," Rosenberg tweeted, adding that it’s "time to take the blinders off."
To the extent the Fed did in fact have its "blinders" on, the May payrolls report may be the last straw for hawkish holdouts. In addition to the grievous miss on the headline print (75k was below even the lowest estimate from 77 economists) both March and April saw sizable downward revisions. Meanwhile, wage growth came in cooler-than-expected (again), bolstering the subdued inflation narrative.
 
I'm writing this on-the-fly, mid-morning, so things could always take a turn for the worst (especially considering how volatile the trade headlines have been recently), but as of 11:30 AM in New York, stocks are on track for another blockbuster session. This is quite something considering how dour the outlook is on trade:
 
(Heisenberg)
 
 
In addition to what markets are "saying" (read: pricing), all of the early commentary on the jobs report underscores the rate cut narrative.
 
"For the Fed, today’s report makes a cut more likely, and supports our view that the trade tensions will ultimately slow growth enough for the Fed to respond in September and December with cuts," BofA said. The bank maintains that June is "too early" for Powell to move and says the Fed may want to "wait after the G-20 meetings to get greater clarity on the current trade negotiations between China and Mexico before altering their outlook for the economy and the path of policy."
 
That underscores a point I've made both here and on my site time and again over the past several weeks (see here for instance). The Fed is in a bind when it comes to cutting rates amid the trade escalations. Easing policy could very well embolden the Trump administration to pursue a harder line with China, thereby raising the odds of further escalations. Overnight on Friday, PBoC Governor Yi Gang, in an exclusive interview with Bloomberg, said Chinese monetary policy has "tremendous" room to respond to any negative developments. Trump last month called for the Fed to "match" the PBoC. If Powell were to cut rates in June or July, it could potentially be seen as the Fed answering that call.
Although Goldman has yet to adopt rate cuts as their base case (as of this writing, anyway), the bank did acknowledge that the jobs report raises the odds of easing. "The risks of Fed rate cuts have clearly increased, and the outcome of trade negotiations will also be a central consideration," the bank said.
 
For their part, Credit Suisse (which sees a rate cut at the July meeting) drove the point home on Friday morning. "A Fed cut in June is still unlikely, in our view, but this report increases the chance that we see a clear dovish shift at their upcoming meeting, followed by a rate cut on July 31st," the bank said, in a short note.
 
Obviously, there is a clear risk that the Fed cannot live up to market expectations for easing. Here's Nomura's Charlie McElligott from a lengthy Friday morning missive:
 
[There's] a meaningful chance that even if the Fed were to move forward with a preemptive 'insurance cut' of up to 50bps in the next 1-3 months, the market implied potential for 4 cuts before the end of next year looks like a 'stretch,' as it would potentially require the worst case scenario double-whammy of 1) Tariffs and 2) Recession.
 
Charlie is probably right (and I should note that his Friday piece is an in-depth look at what's behind the "incessant and almost price-insensitive buying of ED$" on the highs). Indeed, it's entirely possible that even if the Mexico standoff ends in an agreement that averts tariffs, the damage to sentiment is done. The fact that the US is increasingly prone to seemingly random tariff escalations heightens fears about the potential for similar action against Europe (Goldman was out this week assigning a 40% probability to auto tariffs at some point) and further tension with China. That, in turn, will likely weigh on survey data and, potentially, hiring. Remember, the May jobs report doesn't capture the Mexico tariff spat.
 
Going forward, it is all about whether the Fed can engineer a soft landing in the face of what can now be quite appropriately described as wholly unpredictable trade policy and a decelerating US economy.
When you think about all of this in the context of what, as of Friday morning anyway, is shaping up to be the best week for US stocks since November, bear in mind that, to quote a BofA note dated Thursday, "Fed cutting cycles are not usually preceded by a sharp equity market selloff [and] in fact, the S&P 500 on average tends to rise modestly into Fed cutting cycles."
 
 
(BofA)
 
 
Food for thought.