To cut or not to cut?


  • Analyst Reports
  • Saturday, 30 Mar 2019

IN a surprise move last week, not only did the US Federal Reserve (Fed) abandoned its previous guidance of potentially two rate hikes for this year but at the same time reduced the pace of reduction of its own balance sheet, starting in May and looking to end the unwinding of it at the end of the third quarter this year.

With that plan in mind, the Fed’s balance sheet will stand still at US$3.5 trillion in six months time from its current level of about US$3.8 trillion as it runs off US$50bil a month over the next two quarters.

What does this mean for markets?

Since then, the yield on the benchmark 10-year US treasuries dropped by about 21bps from the time Fed made the announcement to 2.4% while the shorter dated two-year papers fell by a faster pace, down by 23bps and was last seen at 2.24%. Interestingly, we also saw a yield inversion between the three-month US treasuries and the 10-year as the spread turned negative and was last seen at -1bps, suggesting a looming recession, causing the Dow to succumb to heavy selling pressure last Friday. With the short end now well below the Fed Fund Rate, the market is already pricing in potential one rate cut in the US anytime soon or as early as in its next meeting on over two days at the end of April.

The Fed, while guiding the market on its monetary police also touched on the US economy as it lowered GDP growth expectations. The central tendency reading for the US economic growth this year is now at between 1.9%-2.2% from the December 2018 projection of 2.3%-2.5%, resulting in the median estimate to be reduced by 0.2 percentage points to 2.1% from 2.3% three months ago.

It’s obvious that the Fed’s move was driven by lack of inflationary pressure as headline inflation has dropped to about 1.5% y-o-y although core inflation remains at 2.1%. As for Personal Consumption Expenditure (PCE) Inflation, the Fed now expects headline readings for this year at 1.8% against 1.9% it projected three months ago. All the lowered projections by the Fed means one thing – there are indeed headwinds on US economic growth, driven by the current trade tensions between the US and China, a slowing Euro and Asia, as well as an uncertain Brexit outcome. US economic data points too have weakened as we saw a surprisingly small job growth data for February and worse than expected housing numbers. Global Purchasing Managers Index for the manufacturing sector has been falling rapidly and was last seen at 50.6 as at February. The coming monthly economic numbers will be interesting set of data as market will likely react negatively if these data points continue to disappoint.

With the fresh projections, is the Fed engineering a recession?

While economic data points are still positive, the lowered projections could mean that we may be in for a recession, perhaps within the next six-18 months, as typically a yield inversion suggests that a recession will occur within that time frame. While some brokers are beginning to advise clients to be mindful of the market signals, risk of recession is still not significant with some tagging it at about 25%-30% based on previous market moves. For Citigroup Inc’s strategist, Ruslan Bikbov, the probability of a recession occurring in the next year is even higher and pegged it at a range of between 37% and 45%.

In general, the likelihood of recession kicking in is when the probability rises to about 70%. But by than, the nation or the world would have already been in recession based on the past economic data points. In other words, we can only know we are in recession when we are already in one. The period of recession, which normally is highlighted in grey in many charts, is normally only added after the event of a recession and not before.

A look at the global bond markets suggests investors’ nervousness is building up with more than US$10 trillion worth of sovereign papers trading at sub-zero yield, led by Switzerland, Germany and Japan’s 10-year bonds. The reason for this market behaviour is obvious. Once the Fed decides to stay pat on rate hike and lowers the US economic growth trajectory, market sees concerns for corporate US earnings growth as the top line of many companies will now be under pressure. This makes stocks unattractive to investors and with the dollar now not expected to gain much ground anymore or worse, due to potential lower Fed Fund Rate, which could weaken the dollar instead, investors see opportunity in non-dollar safe havens, like the Japanese samurai bonds or the German bunds. Hence, nevermind if benchmark papers are in negative yield, investors will gain from currency outlook as dollar will likely be weaker going forward.

Malaysia last had a 25 bps rate cut almost ythree years ago on worries that the global growth at time was moderating while selected Asian economies were experiencing weaknesses in their respective external demand. This in actual fact coincided with Britain’s plan to leave the EU following the results of the 2016 referendum. Looks like all the factors that played out the last time when Bank Negara cut rates is also playing out now. In fact, its even more pressuring for the central bank to cut rates as headline inflation reading has now been sustained at negative 0.5% y-o-y for the first two months of 2019, global growth is slowing while some Asian economies are experiencing even double digit drop in exports when compared with 2018.

In Bank Negara’s recent assessment of the local economy, it highlighted that core inflation remains firm despite the deflation reading for the first two months of 2019.

While that may be the case, the fact that Bank Negara has now lowered the headline inflation expectations for this year to between 0.7% and 1.7% from previously guided 2.5-3.5% range suggests there is indeed room to lower the benchmark Overnight Policy Rate (OPR). The last time the central bank lowered the OPR in July of 2016, the Malaysian economy was slowing down as growth fell to just about 4.1% in 1Q 2016 and to 4% the subsequent quarter while inflation reading was still firm with the May 2016 and June 2016 inflation rate at 2% and 1.6% respectively.

With the current GDP estimate lowered to between 4.3% and 4.8% now against the treasuries’ expectations of 4.9% before, it seems that the current slowing economic conditions are quite similar to those experienced during the first 6 months of 2016 but with much lower inflationary.

With US not going to hike rates for the rest of 2019 and EU too staying the course, it is an opportune time for Bank Negara to lower market rates and perhaps provide some stimulus to private consumption and investments. A 25 bps cut is now a signal that the market is looking at, while a further 25 bps cut cannot be ruled out, given the weakness in global economies and inflation expectations. Failure to act will be deemed to be damaging to the economy as real returns rise and investors or consumers are more than happy to maintain or increase their savings in the banking system. This will discourage private investments and consumption, a key pillar to growth expectations for 2019.

In addition, a central bank needs to stay ahead of the curve and not wait for market to signal the direction the central bank needs to take, like what we are seeing in the US now.

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