Chart 3: US Fed Funds and US Equities

Source: Reuters/ADMISI

THE FEDERAL RESERVE HAS LIMITED ROOM TO PREVENT AN EQUITY SELL-OFF If fixing the trade war in the immediate run up to the election is the re-election strategy, then could an equity sell-off spoil the party?

Despite the 25bps cut at the end July’19 FOMC, the market sold off in a move read as asking the Fed for another rate cut at the next FOMC in mid-Sept’19.

To a greater extent than perhaps any other developed nation, the financial health of the US population depends on a strong equity market, which affects Fed rate policy.

Inflation and unemployment are the two official drivers of Fed rate policy but, ever since the widespread adoption of equity backed pensions almost 30 years ago, the Fed seems to use rates to control volatility in US asset markets.

The chart below shows the period 1986-2003, when US rates reflected volatile financial markets.

Fed Chairman Alan Greenspan first warned of “irrational exuberance” in late 1996 and argued for a rate rise against equity bulls who explained the runaway equity market as a “new paradigm” of inflation free, technology-led growth.

Back then, mature stock markets in the 1990s were buoyed by monthly injections of new pension money at the same time as US manufacturing inflation was exported to China in return for a flood of cheap consumer goods, laying the groundwork for the current trade war.

Greenspan’s attempts to raise rates in 1996/1997 turned into rate cuts in 1997 after the Asian, Russia and LTCM crises hit the global economy, with lower US rates helping drive the “” boom.

Greenspan finally raised rates in 1999, killing off the rally in mid- 2000. Greenspan then cut rates multiple times in 2001 as equities slid lower, successfully averting the type of asset collapse suffered by Japan in 1988-92.

US FED FUNDS AND THE DJIA BETWEEN 1986 AND 2003. RATE CUTS IN 2001 AVERT AN EQUITY MELTDOWN Low US rates between 2003-2006 prevented significant losses in US equities, but low rates also encouraged yield chasing investors to buy into exotic debt instruments (Mortgage Backed Securities including Collateralised Debt Obligations (CDOs)), which financed a housing boom offering low starter rates, becoming unaffordable when rates increased.

Low rates and poor equity returns also encouraged investors into commodities in 2003, pushing “cyclical” commodity markets to unimaginable highs.

Higher rates in 2007 ended the cheap credit and housing boom but triggered the 2008 global financial crisis. Global rates were cut back to near zero by Dec 2008, but in late 2015 a recovering economy allowed the Fed to start increasing rates, reaching 2.5% by Dec 2018 and giving some limited room to cut if required, which started in July.

WHAT NEXT FOR COPPER? Copper prices have been driven by the trade war and, recently, by equities rallying on hopes of easier US rates. To a greater extent than equities, copper appears to be pricing in a longer trade war, perhaps anticipating no fix until mid-2020, timed for the election run-in?

Whilst re-election chances would be improved by an equity rally attributable to a trade war “win” over China, mid-2020 is a long time to wait. If the electorate perceives that the Fed has used limited room on rates to rescue the equity markets from the effects of the trade war, they may be less forgiving.

Fighting an unpredictable trade war with China and no peace in sight, the wall might have been a less expensive option?

Rohan Ziegelaar E: T: +44(0) 20 7716 8081

16 | ADMISI - The Ghost In The Machine | July/August 2019

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