Has Quantitative Easing Re-Entered the Picture?

Jun 21, 2019 | Nick Scholte


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Amid a definite slowdown in the global economy, the European Central Bank contemplates a renewed QE campaign; however, we still do not see a credible and imminent threat of recession

To my clients:

It was an up week for North American stock markets with the Canadian TSX rising 1.4%; the U.S. Dow Jones Index rising 2.4%; and the U.S. S&P 500 rising 2.2%.

There are several points of interest to discuss this week.

First, European Central Bank (ECB) President, Mario Draghi, kicked things off on Monday with very market-friendly comments. He suggested there was “considerable headroom” to scale up the European Quantitative Easing program, something the ECB had previously been looking to unwind. It has been a few years since I’ve had the need to comment upon quantitative easing to any great extent, but recall that in the aftermath of the 2008 financial crisis, under then Chairman Ben Bernanke, the U.S. Federal Reserve began a bond buying program whereby it bought, in massive quantities (measured in the trillions of dollars), long-term Treasury bonds and Mortgage Backed Securities. With such a large buyer of bonds stepping up to the proverbial plate, demand was massively increased and, in accordance with the most basic economic concept of them all, with increased demand comes increased prices. The trickier part comes with understanding that there is an inverse relationship between bond prices and the interest rate received (the yield) on those bonds. In other words, with increased long-term bond prices, comes decreased long-term interest rates. Lower interest rates stimulate an economy insofar as both business (looking to expand their businesses) and consumers (typically seeking long-term mortgages) are incentivized to invest by the lower cost of capital brought about by low interest rates. Bottom line: the ECB looks to be lowering interest rates again.

Second, on Wednesday of this week, the U.S. Federal Reserve held rates steady (as expected). BUT, the bigger news was the language of the accompanying press release, the verbiage used in the post-meeting press conference, and the expectation for future rates as expressed by the individual Fed board members (in the so-called “dot plot” portion of the release). In the press release, the Fed removed the qualifier that it would be “patient” in assessing how economic developments played out. Then, in the very first line spoken at the press conference, Fed Chairman Jerome Powell said the Fed “will act as appropriate to sustain the economic expansion”. And last, future rate expectations expressed by the various board members showed that roughly half the members now expect a rate cut before the end of 2019, with the remaining half expecting no change. Just six months ago the overwhelming expectation of all board members was that there would be two rate increases before the end of the year. This shift further helped to fuel market performance this week. Interestingly, when asked about the possibility that a rate cut of as large as 0.50% might be required by the next Fed meeting in July, Chairman Powell did not dismiss the idea.

Third, President Trump and Chinese President Xi have confirmed that they will indeed have an extensive meeting at next week’s G20 Summit. Trade negotiation teams for both have already re-engaged discussions in the lead-up to this meeting.

All of the above three developments are undoubtedly positive for the markets, but it does beg the question as to why these steps might be necessary. The answer, of course, is that the global economy is definitely slowing, and the central banks of the world want to get ahead of the slowdown. As Fed Chairman Jerome Powell said, the Fed “will act as appropriate to sustain the economic expansion”. In this regard, the current Fed trajectory for interest rates might look most like the late 1990’s when the Federal Reserve made two “insurance” rate cuts that sustained that strong economic expansion for another 2 to 3 years. For what it is worth, RBC Wealth Management expects 0.75% in rate cuts before the end of 2019 – 0.50% in July, and another 0.25% in September, before pausing. RBC also continues to believe that recession will be kept at bay, despite the worrisome signals (albeit, relatively weak signals in the grand scheme of things) coming from the U.S. yield curve. Regarding the U.S. yield curve, it indeed continues to flash yellow (not yet red, because the inversion has been neither deep enough nor sustained enough to reach the “red” threshold), but as has continually been the case, none of the other major recessionary indicators we track have confirmed the yield curve signal. In fact, perhaps our second most important indicator, the trend in weekly jobless claims, has again begun to turn lower (“turning lower” is a positive/good thing for this indicator). And it should be added that a very big reason why the global economy has been slowing is due to the friction and uncertainty brought about the U.S./Chinese trade tensions. But as I’ve long asserted, I think both sides of this dispute are motivated to get a deal done, and I suspect they will (although as I also wrote in recent weeks, my conviction in this expectation has been shaken). Next week will go a long way toward confirming or rebuking this expectation.

Lastly, as readers of these weekly missives likely know from the mainstream news media, there are brewing tensions in the Middle East with oil tankers having been attacked (allegedly by the Iranians), and the Iranians claiming responsibility for shooting down a U.S. drone. In response, President Trump was said to have approved a retaliatory strike against Iran, only to back out at the last moment owing to the fact that he felt the planned U.S. response was not “proportionate” insofar as up to 150 people were expected to die if the retaliatory strike was launched. Certainly any flare up, or direct confrontation, between the U.S. and Iran is a serious development, and it would likely hurt the markets in the short-term. But, as I’ve previously asserted at times like these (i.e. U.S/Syrian tensions, U.S./North Korean tensions etc.), geopolitical flare-ups rarely have lasting economic or market impact, unless of course they devolve into a worst-case outcome, which we all hope won’t happen, and rational self-preserving minds usually prevent from happening.

I think I’ll stop there for this week. I had intended to discuss the newly introduced (by the Federal Reserve) concept of the “effective lower bound” of interest rates vs. the previously adhered to concept of the “zero bound”. But perhaps I’ll save that for next week. Bottom line, although the economic landscape is somewhat murky at present, we still do not see a credible and imminent threat of recession on the horizon, so I am continuing to stay the course on behalf of clients.

All the best,

Nick

Nick Scholte, CIM, FCSI

Vice-President & Portfolio Manager
RBC Dominion Securities Inc. │ Tel: 604.257.7569 │ Fax: 604.235.9950
3200-1055 West Georgia │ Vancouver, BC │ V6E 3P3
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