During the recent period of world growth, where nearly every country’s exports were rising, there was little incentive for governments to manipulate economic policies to foster even more economic growth. Getting back to “normal” seemed to be the universally adopted mantra, and that implied rising rates and tighter monetary policies. However, today, when world trade is contracting (some of which may be due to “trade wars,” but much of which is due to softening worldwide economies), moves by central banks to “stimulate” their economies have a secondary impact, the reduction of their currency’s value relative to the world’s reserve currency. That reserve currency, of course, is the U.S. dollar, and much of world trade is so denominated.
Mercantilism was a practice in Europe a couple centuries back that encouraged trade protectionism because the theory was that a positive trade balance generated wealth. The term “Beggar Thy Neighbor” is a phrase often associated with the concept.
A “Trade” Advantage
When I see the path of interest rates and the explosion of negative yielding sovereign (and now corporate) debt, I can’t help wondering if a form of mercantilism isn’t creeping back into today’s upside-down financial world. With a substantial portion of trade done in dollars, and with worldwide trade now in contraction, the wholesale lowering of interest rates by the world’s central banks weakens the currencies of those particular countries in dollar terms, giving them an “advantage” in terms of trade. While their primary goal may be spurring domestic demand, all the central bankers certainly are aware of this secondary effect.
The Stampede
Despite the apparent “confusion” among the Federal Open Market Committee members (the rate setting committee of the Fed) as to whether the July rate cut should have been 25 or 50 basis points (or none at all according to two such members), as soon as the Fed cut, there was a stampede by other central bankers to follow suit. Early in August, markets were “surprised” by the 50-basis point cut by the Reserve Bank of New Zealand (the expectation was for 25). That same day, India cut by 35 basis points and Thailand by 25. And then Peru pared its policy rate by 25. So far, in 2019, at least as of this writing, 17 central banks have cut rates. This, of course, speaks volumes as to the state of world economies and trade.
Today, fully 25% of the world’s investment grade bonds sport negative yields. In Europe, even some “Below Investment Grade” bonds have negative returns. It was reported, just a week or so ago, that the world’s negative yielders had risen to $12.5 trillion. The latest number is 20% higher at $15 trillion – that, in just a few days,
The Strong Dollar Tweets
That leads me to wonder: If the Fed had cut by 50 basis points, would those other central bankers have cut by more than they did? Highly likely, I think! While they lower rates for the stated purpose of “domestic” stimulus, it appears that a “weaker” currency is an unstated objective. From this analysis, it appears that there is a basis for the President’s tweets complaining about the strength of the dollar.
The Potential Return of Mercantilism
Here is the Fed’s upcoming dilemma: If the U.S. and world economies continue to weaken, and the Fed delivers a policy response by further lowering its administered Fed Funds rate, will that set off a chain reaction where other central banks lower in response? If it does, then we have returned to the world of mercantilism. Worse, it will signal a “race to the bottom,” to 0% or negative rates everywhere, perhaps even in the U.S. Currently, 10-year government yields in Europe (Switzerland: -0.99%; Germany: -0.59%; Netherlands: -0.49%; France: -0.33%; Sweden: -0.29%) make Japan (-0.20%), the poster child for negative yields for more than a decade, look like a high yield country!
The Data
The big worry is that a worldwide recession is on the horizon and that the push toward easy money amplifies the movement toward the zero bound. The latest data are not encouraging:
· German Industrial Production (IP) fell -1.5% in June (consensus was -0.5%) and is down -5.2% from a year earlier;
· India’s IP fell -3.9% in June vs. May;
· French IP fell -2.3% in June;
· Manufacturing PMIs are less than 50 throughout Europe, in Japan, and throughout most of southeast Asia (50 is the demarcation between expansion and contraction);
· Korean exports have fallen 8 months in a row;
· Malaysia reported negative growth in exports in June (first negative monthly report);
· China’s Caixin Manufacturing PMI was below 50 in both June and July;
· Auto sales in India were down -24% in June on a year/year basis;
· Korea and Japan are in a trade dispute of their own impacting tech sector supply chains;
· UK Q2 GDP growth was -0.2%; IP -0.1% in June vs. May and -0.6% year/year;
· The Baltic Dry Index, a bellwether for dry bulk shipping worldwide, has fallen nearly 40% since the start of 2019;.
· U.S. ISM Manufacturing PMI: 51.2 (July) vs 53.7 (June), a three-year low;
· In the latest U.S. jobs report, there was contraction in the workweek, in manufacturing hours, and in factory overtime;
· For the first time in a long time, Americans used less oil (in the week ended August 2, oil consumption was slightly lower than in the same week in 2018);
· U.S. consumer credit card balances fell in June;
· U.S. ISM Non-Manufacturing PMI fell to 53.7 (July) from 55.1 (June). While still positive, the size of the drop is of great concern. Nearly every sub-index showed substantial declines.
Conclusions
In a recent interview, Jeffrey Gundlach, the CEO of Doubleline Capital and the new U.S. “Bond King,” placed the odds of a recession in the next year at 75%. Recession models at the various regional Federal Reserve Banks have shown heightened risks. Every company that has a recession model has noted high and rising recession probabilities.
When the U.S. Fed lowers rates again, which, given the data above, seems inevitable, if the same pattern is followed by the world’s central bankers as the one that just occurred, interest rates will be pushed further down. How deeply negative some will go is anyone’s guess. Worse, the mercantilism of weakening one’s currency for trade advantage may likely become quite apparent with attendant political ramifications.
Robert Barone
Robert Barone, Ph.D. is a Georgetown educated economist. He is a financial advisor at Four Star Wealth Advisors. www.fourstarwealth.com. He is nationally known for his writings and Robert’s storied career includes his having served as a Professor of Finance, a community bank CEO, and a Director and Chairman of the Federal Home Loan Bank of San Francisco. Robert is currently a Director of CSAA Insurance Company (the AAA brand) where he chairs the Finance and Investment Committee. Robert is the co-portfolio manager of the UVA Unconstrained Medium-Term Fixed Income ETF (FFIU).