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David Fuller and Eoin Treacy's Comment of the Day
Category - Fixed Income

    What's Wrong With the 2 Percent Inflation Target

    This article by Paul Volcker may be of interest to subscribers. Here is a section:

    Only once in the past century, in the 1930s, have we had deflation, serious deflation. In 2008–2009 there was cause for concern. The common characteristic of those two incidents was collapse of the financial system.

    We can’t expect to prevent all financial excesses and recessions in the future. That is the pattern of history with free markets, financial innovation, and our innate “animal
    spirits.”

    The lesson, to me, is crystal clear. Deflation is a threat posed by a critical breakdown of the financial system. Slow growth and recurrent recessions without systemic financial disturbances, even the big recessions of 1975 and 1982, have not posed such a risk.

    The real danger comes from encouraging or inadvertently tolerating rising inflation and its close cousin of extreme speculation and risk taking, in effect standing by while bubbles and excesses threaten financial markets. Ironically, the “easy money,” striving for a “little inflation” as a means of forestalling deflation, could, in the end, be what brings it about.

    That is the basic lesson for monetary policy. It demands emphasis on price stability and prudent oversight of the financial system. Both of those requirements inexorably lead to the responsibilities of a central bank.

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    Stock Markets Face Historic Lack of Dry Powder

    This article by Julie Segal for Institutional Investor may be of interest to subscribers. Here is a section:

    “The main reason is simply that the more a relationship moves to an extreme end of its range, the more likely it becomes that it will begin to move back toward its longer-term average.”

    A historically high level of assets in money market funds, which are a home for risk-averse investors, would generally indicate that investors are feeling cautious. But Becker argued that relative to equity fund assets, money markets are actually low.  

    Becker said that for asset level data he used the full history offered by Morningstar, which goes back to February 1993, covering 25 years of data. “This suggests that over the last 25 years investors have never felt more confident,” he says. 

    In this case, such a move could happen quickly or slowly. It could happen more slowly through changes in allocations of new money (e.g. investors decide to stop putting new 401[k] money into equity mutual funds and start putting it into MMFs). Or it could happen quickly through a sharp decline in the stock market, causing equity funds to and money-market fund assets to get larger relative to equity fund assets.

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    The next recession

    This article from the Economist may be of interest to subscribers. Here is a section:

    Yet this is where the bad news comes in. As our special report this week sets out, the rich world in particular is ill-prepared to deal with even a mild recession. That is partly because the policy arsenal is still depleted from fighting the last downturn. In the past half-century, the Fed has typically cut interest rates by five or so percentage points in a downturn. Today it has less than half that room before it reaches zero; the euro zone and Japan have no room at all.

    Policymakers have other options, of course. Central banks could use the now-familiar policy of quantitative easing (QE), the purchase of securities with newly created central-bank reserves. The efficacy of QE is debated, but if that does not work, they could try more radical, untested approaches, such as giving money directly to individuals. Governments can boost spending, too. Even countries with large debt burdens can benefit from fiscal stimulus during recessions.

    The question is whether using these weapons is politically acceptable. Central banks will enter the next recession with balance-sheets that are already swollen by historical standards—the Fed’s is worth 20% of GDP. Opponents of QE say that it distorts markets and inflates asset bubbles, among other things. No matter that these views are largely misguided; fresh bouts of QE would attract even closer scrutiny than last time. The constraints are particularly tight in the euro zone, where the ECB is limited to buying 33% of any country’s public debt.

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    U.S. Treasury Staff Said to Find China Isn't Manipulating Yuan

    This article by Saleha Mohsin and Jenny Leonard for Bloomberg may be of interest to subscribers. Here is a section:

    Treasury said in its April report that it is considering expanding the number of countries it examines from 13, with analysts speculating that the number could go as high as 20. Such a move would be a sign of the Trump administration ramping up its use of the currency channel to negotiate better trade deals for the U.S.

    Mnuchin has said since July that Treasury is concerned about the yuan’s recent drop. The currency has slid more than 9 percent against the dollar in the last six months, raising speculation that China has been deliberately weakening its currency as tensions with the U.S. escalate.

    The Trump administration has pivoted to a more aggressive stance toward China since the president said last month the country is interfering in U.S. elections. Vice President Mike Pence delivered a speech last week in Washington signaling a firmer U.S. push-back against Beijing as trade anxiety weighs on the looming midterm congressional elections.

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    Treasuries Slide Pushes 10-Year U.S. Yield to Highest Since 2011

    This article by Liz Capo McCormick for Bloomberg may be of interest to subscribers. Here is a section:
     

    The yield on 10-year Treasuries, a benchmark for global borrowing, rose to the highest level since 2011 amid growing optimism about the U.S. economy. The rate on 30-year securities reached a four-year high and the dollar gained.

    Improved investor appetite for riskier assets drove the leap in yields, with stocks rising toward records on upbeat news about American jobs and ebbing concern about the fiscal situation in Italy. The jump in yields Wednesday, which pushed them above previous 2018 highs set in May, followed stronger-than-anticipated reports on U.S. services and private payrolls and came after the Federal Reserve lifted interest rates last week.

    The government reports payroll figures for September on Friday, and economists forecast a decline in the jobless rate to 3.8 percent. It hasn’t been lower since 1969.

    Treasuries are extending a September swoon that was triggered in part by quicker-than-forecast wage growth in employment data released early last month.

    “This started overnight with the Italian risk-on trade and the U.S. data today was definitely stronger” than forecast, said Justin Lederer, an interest-rate strategist at Cantor Fitzgerald in New York. “After last month’s payroll, the market started to catch up to the Fed and it’s a continuation of that. There is reason to be believe we can continue to trickle to higher yields.”

    The yield on the 10-year borrowing benchmark climbed as much as 7 basis points Wednesday to 3.1343 percent, surpassing the May intraday high of 3.1261 percent. The yield on the 30-year increased as much as 7 basis points to 3.29 percent.


    Money-market traders are now pricing in more than two Fed hikes in 2019, seeing about 0.54 percentage point of tightening, approaching policy makers’ projections for three rate increases next year. About two months ago, the market saw just slightly
    more than one increase.

    The yield curve, which has been on a flattening trend for much of this year, steepened sharply amid Wednesday’s break-out in long-term yields.

    The gap between 2- and 10-year yields surged more than 3 basis points to about 28 basis points, reaching its steepest since August.

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    Italy Contagion Fears Bubbling Beneath Surface of Apparent Calm

    This article by John Ainger for Bloomberg may be of interest to subscribers. Here is a section:

    For others, Italy’s euroskeptic government is just the embodiment of the populist sentiment taking root across Europe, which could threaten the bloc’s future and weigh on the euro for the months or even years to come.

    Borghi, head of Italy’s lower house budget committee and a well-known euroskeptic, said in an interview on Radio Anch’io that “Italy, with its own currency, would be able to resolve its problems.”

    “The comments about Italy having its own currency have touched a sore point,” said Jane Foley, head of foreign-exchange strategy at Rabobank International. “While the return of the lira would be almost impossible and hugely inflationary even if it could happen, the fact that the remarks can be read as anti-EMU sentiment are worrisome.”

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    Italy's government agrees sharply higher public spending plan

    This article by Miles Johnson and Davide Ghiglione for the Financial Times may be of interest to subscribers. Here is a section:

    Mr Di Maio hailed the agreement as a “historic day”. “We made it!,” he said as he emerged from a balcony at Rome’s Palazzo Chigi, where the meeting took place.

    “Today we have changed Italy! . . . For the first time the state is on the side of the citizens,” he said as ministers and members of parliament from his party hugged each other on the square outside.

    Matteo Salvini, leader of the hard right League, part of the coalition and deputy prime minister alongside Mr Di Maio, also welcomed the agreement on spending, saying he was “fully satisfied with the objectives achieved”, which would include his party’s pledges for tax cuts and a reversal of unpopular pension reforms dating back to 2011.

    Mr Tria, who is not affiliated with either party and was installed only after Italian president Sergio Mattarella rejected the coalition’s first choice for finance minister, had been pressing for a deficit number as low as 1.6 per cent of GDP going into the meeting.

    A 2019 deficit of 2.4 per cent of GDP would represent a significant fiscal expansion from the 1.6 per cent target for this year agreed by the last centre-left government, and would be three times the 0.8 per cent number previously planned for next year.

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    Neutral Fed Funds, Dead Ahead

    This article from Bloomberg’s economists may be of interest to subscribers. Here is a section:

    Given the lagged and variable impact of monetary policy on economic conditions -- further complicated in the current cycle by the Fed’s balance-sheet unwind -- policy makers will need to navigate with caution when in the proximity of neutral. Fed Chairman Jerome Powell, in his Jackson Hole speech, sounded dual warnings about this: First, he stressed economists’ inability to estimate the neutral level of interest rates in real-time and cautioned against the “mistake of overemphasizing imprecise estimates of the stars”; second, he invoked the Brainard principle, which advocates moving conservatively on policy when the effects of action are unknown.

    If growth is moderating toward trend and inflation appears to be centering around policy makers’ objective as the fed funds rate probes neutral territory, a significant portion of the FOMC should be willing to slow -- if not pause -- the pace of interest-rate increases in order to assess economic conditions. Policy makers may not be able to precisely identify the neutral policy rate in real time, but a continual decline in the terminal fed funds rate over the past several tightening cycles (shown below) serves as a cautionary reminder that, as Powell quipped at Jackson Hole, a “smaller dose” of normalization may prove adequate.

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