Broker Check

The press is raving about the “inverted yield” curve

August 14, 2019
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More than five years ago the European Central Bank adopted negative interest rates as a policy tool to address economic weakness in the Eurozone. Starting at -0.1%, eventually, the target short-term rate fell to -0.4%. In Europe, as in every country or region that has tried Quantitative Easing, banks have not increased loans by the amount that QE suggested. As a result, central banks (like the ECB) have attempted to force banks to lend by "charging" banks (with negative rates) to hold these excess reserves. Negative interest rates are "man-made"," not something that has happened organically. More importantly, they prove QE didn't work. If QE worked, then negative interest rates wouldn't be necessary.
 
Now policymakers are nearly in a panic because some key Eurozone economies are sputtering. Germany's industrial production was down 5.2% in June versus a year ago, the largest drop since 2009. Meanwhile, many now expect that German real GDP contracted in Q2. Italy's economy hasn't grown in the past year and France's economy is up only 1.3% from a year ago.
 
Some economies in Europe are doing well, particularly Poland and Hungary, but these aren't large enough by themselves to power the whole Eurozone higher. It's time for Europe to recognize that neither negative interest rates nor quantitative easing has saved their economies. By using negative rates, the ECB has been trying to punish banks into lending, and it hasn't worked. Worse, negative rates are, in effect, a tax on the financial system. As a result, they undermine bank profitability and weaken the financial system.
 
Instead of looking toward monetary policymakers to rescue their economies, they needed to point their fingers at the real culprits all along, bad fiscal and regulatory policies. Germany, for example, is still running budget surpluses even though investors buying their debt are willing to accept negative rates. This is absurd. This isn't to say the German government should spend more, spending is already too high. But Germany has room for deep tax cuts oriented toward boosting incentives for investment and economic growth. Increasing the incentive to produce would, in turn, generate the growth in lending that negative interest rates were supposed to encourage.
 
On top of tax cuts, we'd recommend cutting government transfers to non-workers (yes, that includes limiting the generosity of future government retirement benefits) and regulations that have stifled entrepreneurship. Hopefully, the US learns the right lessons from Europe's crazy negative rate approach, which is an admission of failure by government officials. In the 1980s, the US saw real GDP growth of 4% - not because of low (or negative) interest rates - but because of better fiscal policies. Paul Volcker actually held interest rates high while President Reagan pushed through tax rate and regulatory reductions and spending restraint. Those policies strengthened the dollar and the economy. That's what works.
 
Today, the press is raving about the "inverted yield" curve (longer rates are lower than short rates). It is, they say, a guarantee of a recession in the future. They have difficulty saying when though. How ridiculous. All business cycles end in a recession or close to it. A recession is a certainty in the future, but that could be two to three years away, not now. Why the panic? A recession is two quarters in a row of negative Gross Domestic Product (GDP). We aren't even close to that. In fact, the GDP may be accelerating. Our economy is still strong and growing. This downturn in stocks is predictable after a 20% rise in the markets in the first 6 months. Expect some strong gains in the final quarter.
 
Equities: Equity markets declined last week on average weekly volume, despite it being a summer trading month. The markets were almost entirely macro headline-driven as there were not too many significant movements due to earnings being released. The Russell 2000 small-cap stock index officially moved into correction last week, as it was down more than 10 percent from its peak back in late August of 2018. (Understand that 10% corrections happen almost every year.)
 
○ S&P 500 (-0.46%) - Average volume
○ NASDAQ (-0.56%) - Average volume
○ Dow (-0.75%) - Average volume
○ Russell 2000 (-1.34%) - Average volume

Source : Monday Morning Outlook 8-12-19: Callahan Capital Management Weekly Commentary 8-12-19


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