What is the economic impact of tighter US monetary policy?

It is time for us to look West again and see what is happening in the new world and this week has brought a curious development. Ordinarily it is central bankers telling us about wealth effects and then trying to bathe in the implications of their own policies but in the US right now there is an alternative.

Stock Market up more than 400 points yesterday. Today looks to be another good one. Companies earnings are great!

That is from the Twitter feed of @realDonaldTrump and continues a theme where this seems if numbers of tweets on the subject are any guide to be his favourite economic indicator. Indeed on Tuesday he was tweeting other people’s research on the matter.

“If the Fed backs off and starts talking a little more Dovish, I think we’re going to be right back to our 2,800 to 2,900 target range that we’ve had for the S&P 500.” Scott Wren, Wells Fargo.

There is a danger in favouring one company over another when you are US President especially with the recent record of Wells Fargo. But the Donald is clearly a fan of higher equity markets, especially on his watch, and was noticeably quiet when we saw falls earlier this month. This does link in a way with the suggestions of a trade deal with China that boosted equity markets late on yesterday, although with the People’s Bank of China hinting at more easing the picture is complex.

The US Federal Reserve

Unless Standard and Poorski is correct below then the Fed is currently out of the wealth effects game.

FEDERAL RESERVE ANNOUNCES IT WILL BEGIN PURCHASES OF APPLE IPHONES AND IWATCHES AT A PACE OF $1 BILLION PER MONTH

One cautionary note is that humour in this area has a habit of becoming reality later as someone in authority might see this as a good idea. Also even the many central banking apologists may struggle with the US Fed buying Apple shares from the Swiss National Bank.

The current reality is rather different because as we stand QE ( Quantitative Easing) has morphed into QT  where the T is for Tightening. For example yesterday’s weekly update told us that its balance sheet  has shrunk by US $299 billion dollars to  US $4.1 trillion and the reduction was mostly due to the sale of US Treasury Bonds ( US $173 billion) followed by US $101 billion of Mortgage-Backed Securities. Over the next year we will expect to see around double the rate of change if it continues at its new raised pace.

 Effective in October, the Committee directs the Desk to roll over at auction the amount of principal payments from the Federal Reserve’s holdings of Treasury securities maturing during each calendar month that exceeds $30 billion, and to reinvest in agency mortgage-backed securities the amount of principal payments from the Federal Reserve’s holdings of agency debt and agency mortgage-backed securities received during each calendar month that exceeds $20 billion. ( Federal Reserve ).

Consequences

From the Wall Street Journal on Monday.

After hovering around 2.3% for most of the spring and summer, the three-month London interbank offered rate, or Libor, has been climbing since the middle of September, settling at 2.53% on Monday, its highest level since November 2008.

I am sure most of you are thinking about the rises in US official interest-rates and the shrinking balance sheet as well as the year-end demand for US Dollars I looked at back on the 25th of September . Well your Easter Egg hunt looks likely to be much more fruitful than the one at the WSJ.

Analysts don’t fully know why the spread has moved the way it has in recent months.

If we ignore the why and move onto what happens next? Lisa Abramowich of Bloomberg is on the case.

3-month U.S. Libor rates have surged to a new post-crisis high, of 2.54%, more than double where it was last year. This is important because so much debt, including leveraged loans, are pegged to this rate. Companies will find themselves paying more interest on their debt…

As to how much debt I note Reuters have been estimating it at US $300 trillion which even if we take with a pinch of salt puts the Federal Reserve balance sheet into perspective. Oh and remember the booming leveraged loan market that had gone to about US $1.1 trillion if I recall correctly? Well Lisa has been on the case there too.

Short interest in the biggest leveraged-loan ETF has risen to a record high.

So in areas which bankers would describe as being “innovative” we see that Glenn Frey is back in fashion.

The heat is on, the heat is on, the heat is on
Oh it’s on the street, the heat is on

We can add that to the troubles we have seen in 2018 in emerging markets as the double combination of higher US interest-rates and a stronger Dollar have turned up the heat there too.

The US Dollar

Firstly we need to establish that whilst talk of challenges abounds the US Dollar remains the world’s reserve currency. So a rise impacts on other countries inflation via its role in the pricing of most commodity contracts and more helpfully may make their economies more competitive. But if we are looking for signs of trouble it hits places which have borrowed in US Dollars and that has been on the rise in recent times. I have reported before on the Bank for International Settlements or BIS data on this and here is the September update.

The US dollar has become even more dominant as the prime foreign currency for international borrowing. Dollar credit to the non-bank sector outside the US rose from 9.5% of global GDP at end-2007 to 14% in Q1 2018…….The growth in dollar borrowing by EMEs or  emerging market economies  has been especially strong, but dollar exposures vary substantially both across countries and in terms of sectoral composition.

An example of this has been Argentina which is caught in a trap of its own making as for example a devaluation would make its US Dollar debts more expensive. Or if we look at India it seems its shadow banks have caught something of a cold in this area.

India Is Said to Expect Shadow Banking Default Amid Cash Squeeze- Bloomberg Non-bank financiers and mortgage lenders have 2.7 trillion rupees ($37 billion) of debt maturing in the next five months, immediately ( @SunChartist )

 

Comment

So far we have mostly looked at the international impact of US monetary policy so let us now look more internally. If we look at interest-rates then the 30 year fixed rate mortgage has risen to 4.83% having started the year at 4% and which takes it back to early 2011. This reflects rising Treasury Bond yields which will have to be paid on ever more debt with official suggestions saying US $1.34 trillion will need to be issued in the next year.

Against that the economy continues to be in a boom. We will find out more later as for example will wages growth reach 3%? But economic growth has been above that as the last 6 months suggests around 3.8% in annual terms assuming it continues. So for now it looks fine but then it always does at times like this as for example a slow down and rising bond yields could in my opinion switch things from QT to QE4 quite quickly. After all worries about US stock market falls  started with it still quite near to what are all time highs.

Also if you want some more numbers bingo the BIS provided some more for Halloween.

The notional value of outstanding OTC derivatives increased from $532 trillion at end-2017 to $595 trillion at end-June 2018. This increase in activity was driven largely by US dollar interest rate contracts, especially short-term contracts.

 

 

 

 

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19 thoughts on “What is the economic impact of tighter US monetary policy?

  1. Sitting here early morning Florida, waiting for next Tuesday’s results. If the house stays red, expect Trumpt to put almighty pressure on the Fed to ease off the tightning, he wants to break through 5% GDP. If the house goes blue, the Fed will continue tightening and GDP growth will slow to 3% or less.

  2. As an economics newbie, how comes is it that US raising rates (and seemingly continuing to raise) has seen no pressure put on the UK to follow suit?

    Carney does the same old trick of threatening something and never doing it. It does seem more likely to me that the end of 2019 will see us back at 0.25% rather than 1.25%.

  3. The place I’m looking is at the EFT’s and your quite staggering BIS figure for OTC derivatives. I shall be humming this song for the rest of the day I think…

    Damn blast, look at my past
    I’m ripping up my feet over broken glass
    I said, Oh wow, look at me now
    I’m building up my problems to the size of a cow…

    • Hi bill

      I have to say I was a bit embarrassed when I looked that up as it is a song I know but perhaps not as well as I thought. I do enjoy the mix-ups put on You Tube and the next one was Cool for Cats.

      Returning to the numbers some care is needed as for example in one of my main stomping grounds of interest-rate derivatives the actual moves give changes which are way smaller than the notional exposure. Except the times they may have headed further in that direction came from the central bankers themselves with the large post credit crunch rate cuts and then NIRP. As I have posted before I recall being in the main exchange options trading pit where we collectively dismissed NIRP on the basis of our expert knowledge which of course was a bit less expert than we thought. So some positions were no doubt based on it being impossible.

  4. Shaun, it is the story of the year of 2018. USA breaks out from QE free money and weaponises the dollar to remind the ROW that TRUMP is the reserve currency.

    I had to look up the acronym… Definition of over-the-counter OTC. A stock that is not listed on an exchange. Trading is carried out directly between dealers over the telephone or by computer. [ 1] Over-the-counter derivatives stem from deals negotiated bilaterally and privately between two parties rather than traded on a formal securities exchange.

    I am guessing that these are the shadow bank bets on the money promises around the world, apparently the London market hosts a massive lump of them too. 10x the EU market GDP. These need to be carefully relocated in shock-proof containers to Frankfurt as part of our disorderly Brexit deal……apparently.

    So,I think remarkably this is the dog which did not bark for Developed Economies in 2018 although it was certainly felt and pointedly by all the EM’s.

    Amazingly, UK, CA, AU, EU NZ all managed to keep their eyes down and pretend that free money is still the way forward… despite the Trump Gorilla playing a different tune. I am thinking 2019 might be the year that these debt-loaded countries get a shock. They are probably hoping that Trump America fails in their break-out, loses reserve currency status and returns to QE.

    I don’t see it can go on for whole another year… somethings gotta give, we will see together on Shaun’s blog.

    • Hi Paul C

      To add to your explanation there are two main differences between exchange and OTC derivatives.

      1. Exchange contracts are standardised in terms of size and expiry date whereas OTCs are whatever you want.
      2. Exchange contracts have a clearing house and are settled each night in terms of margin calls. OTCs do not.

      As to who does them then obviously OTCs tend to be more specialist but there is no restriction as to who as long as who you are dealing with thinks you can back it up. Also there are links as I have for example been involved in writing OTCs on the UK Gilt market and hedging with exchange futures and options.

      • Thanks Shaun, for educating me,OTC sounds a casino approach to making money, kinda betting on better knowledge, models or just gut feel.

  5. Hi Shaun

    Trump is inclined to take credit when the stock market goes up (it’s me me me) but it’s the fed’s fault when it goes down.

    Trump will not like the latest NFP figures which are right at the higher end of estimates, still less the report on hourly earnings which have accelerated to 3.1%. These give the Fed ammunition to keep tightening.

    In fiscal terms Trump has gone “all in” with the US facing huge deficits in the next few years. This, together with (for now) rising interest rates is going to ratchet up the US interest bill very substantially and, sooner or later, crowd out spending. As you say this position will be exacerbated mightily if there is a slowdown (inevitable) which pushes borrowing up substantially and QE4 will follow.

    If this cycle of QE and then tightening goes on sooner or later the penny will drop that something is wrong. ?That, however, assumes we do not have a crash in the interim which I think is most unlikely.

    • Hi Bob J

      There is a road out of this for the US but it requires 3% or so economic growth for the next few years. For national debts De La Soul were tight that three(%) is the magic number. But as you say that is not especially likely in a world which seems increasingly unable to take any form of setback these days.

  6. Even in an age where billions have replaced millions and trillions replace billions, the $595 trillion in derivatives seems like pretty serious money.
    In May, it was reported that Deutsche Bank has a derivatives book of $157 trillion.
    Deutsche Bank has a market capitalisation of Euro 19 billion, so its derivatives book is 8200 the size of its net worth.
    What could go wrong?

    • Hi James

      Well if you look at the Deutsche Bank share price some of it seems to have gone wrong already! Even with an activist investor buying around 3% of the shares recently it has only struggled above 9 Euros today. Which kind of illustrates your point I think.

    • Yes James, big numbers.
      If you had a (large enough) bucket containing $595 trillion and 30 people each took out one $20 bill every second it would take over 30,000 years to empty it.

  7. Is it the defence of the US$ (against de-dollarization) as a reserve currency by highlighting the weaknesses of other currencies like the Renminbi and Euro?

  8. Great blog as usual, Shaun.
    Chairman Powell continues gamely to say that the 2.0% inflation target of the US Fed is symmetric. However, after the September update the annualized rate of inflation for the PCEPI from January 2012 to September 2018 was only 1.35% (1.60% for core PCEPI as measured by PCEPILFE) so this doesn’t match the facts. In September the annual PCEPI inflation rate slipped from 2.22% in August to 1.99%, ending six months was above target, but peaking at just 2.35% in July. Although Chairman Powell usually only mentions the PCEPILFE at press conferences, the FOMC also puts a lot of stock in its trimmed mean core measure and its annual inflation rate also dropped below 2.0% in September to 1.99% after just two months above 2% (at 2.03%!). This certainly doesn’t mean that another hike in the federal funds rate is out of the question, but if it happens it would be hard to square with a symmetric target rate. Maybe the FOMC should just agree that henceforth the US Fed will be adopting a 1.5% target inflation rate.
    The new USMCA (aptly called NAFTA 0.8 by the Mexican negotiators) contains a Chapter 33, Macroeconomic Policies and Exchange Rate Matters, which, as Stephanie Segal noted: “affirms the three countries’ commitment to market-determined exchange rates and adherence to the International Monetary Fund’s (IMF) Articles of Agreement to ‘avoid manipulating exchange rates or the international monetary system in order to prevent effective balance of payments adjustment or to gain an unfair competitive advantage.’” This chapter might well have been in reaction to the currency war that US policymakers complained Bank of Canada Governor Poloz was waging against the US. However, something like it could become boiler plate in future international trade agreements signed by the Trump administration, including a US-UK trade agreement, if there ever is one. Since July 2017 the Canadian bank rate has pretty much followed the US bank rate, and it appears like the Trump administration wants to institutionalize arrangements whereby central banks of trading partners follow monetary policies that mesh with America’s.

      • No, not at all, Paul. The Teranet National Bank 11-City-Composite House Price Index had its annual inflation rate peak at 14.2% in June 2017; it was only at 2.1% in September 2018. A lot of the drop came from Toronto, which went from 29.3% to -0.8% and Hamilton, which went from 25.6% to 1.4%.

        • Andrew thanks for the numbers,dont seem too bad. but I guess an index averages the year and the trend and speed of direction can be delayed or indeed hidden in the short term. Actual sales prices against last deal for the previous fortnight might be a better now indicator. But thanks, keep us informed how Trump damages your economy. 🙂

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