Today I’m sharing just a short note to highlight one fascinating chart that in my view encapsulates the macro narrative thematically all by itself. Credit to my colleague David Tan for featuring it amongst the hundred or so charts we studied during last week’s GFICC Investment Quarterly (IQ) meeting.
Broadly speaking, we know the so-called “soft” data is looking up – that is, surveys of sentiment, business conditions, outlook, and measures of intent are all showing very encouraging positive readings. And we also know the “hard” data – that is, live measures of output, spending, and investment, have yet to definitely turn higher. If anything, Q1 2017 GDP in the U.S. is likely to read optically quite low (sub-2%) for a variety of arcane reasons. And yet, equities are at all-time highs, credit spreads are close to multi-year tights, and the interest rate market is signaling green shoots of “normalization” for the first time since the old normal. It feels like all of this is built on a big stack of optimism, and as long as we’re waiting for policy changes to arrive, there is no more to the foundation than hope. Notwithstanding our view that real policy changes are coming on taxes, regulation, and fiscal stimulus, it is also our view that the optimism itself is significant enough to materially improve the near-term prospects for growth.
The illustrated chart depicts a subset of the University of Michigan Consumer survey, where respondents cite “government” or “elections” as justification for their opinions on business conditions. This is the essence of soft data; it’s a survey, and it’s qualitative. But to say it’s turning up is an understatement. There has been a once-in-a-generation shift in the perceived relationship between government and business. Perhaps it’s obvious, but this is the sentiment shift which is driving all other sentiment shifts.
It’s well understood that small businesses and startups are a potentially significant driver of job creation and incremental growth in the U.S. , and that entrepreneurship cratered during the financial crisis. It has not bounced back. And yet, this chart depicts something extraordinary. For the first time in the 40-year history of the time series, a meaningful percentage of consumers feel that business conditions are favorable because of the government. Sure, there has been a spike in those viewing conditions unfavorably, but that statistic is no worse than it was during the Obama administration, and some level of pessimism seems rather typical. What’s atypical is government-derived optimism. The magnitude of the consumer optimism exceeds the next closest period by a factor of three. To boot, the participants in this survey are typical U.S. consumers, the same pool of people the economy draws upon for small business and startup entrepreneurship.
This extraordinary shift in the outlook encapsulates the significance of the 2016 election for the U.S. economy. The economy, after all, is made up of individuals, and the risk tolerance of a large constituency is almost certainly improving with this shift view of the government. By extension, so too is the likelihood they will form businesses that create jobs, and add new value to our economy. Growth derived from the grassroots level, as opposed to the corporate behemoth level, is not dependent on closing the yawning manufacturing competitiveness gap nor is it dependent on reversing the trend toward automation. On the contrary, diverse entrepreneurship can exploit these realities as strengths.
Since the ECB meeting earlier this month, there has been increasing speculation that they may raise the deposit rate, currently set at -0.4%, before beginning to taper their Quantitative Easing (QE) programme, currently set at €80bn of bond purchases per month. Most recently, Ewald Nowotny from the Governing Council explained that the central bank need not follow the same timeline as the Federal Reserve, addressing the possibility they could raise rates first.
Although it is not inconceivable that the ECB may move away from negative rates before tapering, our base case remains that they will step back from QE first. The most likely process will involve a six month taper starting in January 2018 and ending by June. We believe it is possible that they begin to raise interest rates whilst tapering but that it is unlikely they do so beforehand. The market currently expects the ECB to return to a positive base rate by around the end of next year.
That said, there are good arguments as why the ECB would raise rates first and I have outlined some reasons for and against this below.
Why would the ECB hike first?
It can be argued the ECB should remove the most unconventional measure of monetary policy first and it is a matter of opinion which policy is more unconventional. Most developed market central banks have added QE to their basket of monetary policy tools whilst only some have ventured into negative rate territory. Furthermore although negative real rates are nothing new, negative nominal rates are much harder for the consumer and general public to appreciate or even understand.
Secondly, the Eurozone countries most in need of accommodation and with the largest amount of slack are in the periphery. Raising rates before tapering would tighten conditions in Germany by raising core rates, however, would prevent peripheral spreads from selling off too much and putting pressure on those economies and their ability to finance their debt.
Lastly, for the ECB it is somewhat political. Negative rates are disliked by many sectors of the economy including banks and savers. Banks are forced to pay for the privilege of holding cash at the central bank. Whilst most of their assets are repriced by movements in the yield curve, banks are unable to pass on negative rates to their depositors.
What is wrong with these arguments?
Despite their merits, these arguments are not completely convincing. Even if the ECB wanted to hike rates first, they are beginning to hit their own constraints on the share of each bond issue they can buy. As you can see in Chart 2, they were forced to half the duration they took out of the market in Germany last month. A lack of willingness to relax this rule means they are on a pre-set course to taper, regardless of the state of the economy, as we approach the end of the year. Why would the ECB commit to even more tightening concurrently, especially with core inflation still so low (see Chart 3)?
Secondly, it is by no means obvious that raising rates whilst continuing QE would help keep conditions in the periphery easy. After all, higher rates in the core would diminish the attractiveness of taking credit risk in the periphery. More importantly, peripheral companies tend to borrow shorter term meaning they are more impacted by the front end of the curve than their German counterparts.
Lastly, on the political side, it is not obvious that the German ECB members who form the most hawkish part of the committee would be arguing to raise rates before ending QE. Perhaps most importantly, QE is not a financial stability tool and redirecting QE away from the capital key towards countries of stress would bring with it many legal questions. This is the main reason the ECB has tried not to deviate from their planned purchases too much.
In conclusion, both arguments have their merits and although it is not our base case, it is a possibility that the ECB raise the base rate first. The current forward guidance is that rates are “expected to remain at present or lower levels for an extended period of time, and well past the horizon of our net asset purchases.” That said, the ECB has changed its communication many times before.