Enjoy the torrid Fed rally, but the world is not out of the woods yet

The world can breathe a little easier. The US Federal Reserve has come to the rescue of a global economy slowing to stall speed. It has extended a lifeline to a China sinking ever deeper into a debt-deflation trap.

The Fed has relieved pressure on the $13 trillion nexus of dollar-denominated debt traded offshore. The Bank for International Settlements says emerging markets have racked up $5.2 trillion of dollar debt – from companies in Brazil, or Kazakhstan or Korea.

This understates the true scale of borrowing embedded in the derivatives market – FX swaps, forwards, etc – which pushes the dollar liabilities of non-US banks to over $35 trillion. This has to be rolled over continuously. “Much of this debt is very short-term,” said the BIS.

The start of a Fed rate-cutting cycle is a huge moment for the international financial system. Central banks in emerging markets can loosen a little without fearing a run on their currencies. Indonesia’s central bank has stopped defending the rupiah and dared to cut rates. India’s Sensex stock index hit an all-time high on Thursday as markets anticipate a new world of abundant liquidity and surging inflows of foreign funds.

The Fed’s jumbo half-point cut is transmitted instantly to the 40-odd countries and currency boards linked to the US dollar in one way or another. These regions were forced to import the most aggressive tightening cycle in 40 years through their exchange rates, whether or not their local economies were synchronised with the US cycle.

Hong Kong’s banks have finally been able to cut their suffocating prime rate. Over 90pc of the enclave’s mortgages are on floating rates tied to three-month Hibor, the “dollarised” interbank benchmark. The Hong Kong property market may start to come back from the worst crash since the Asian financial crisis in 1998.

The Fed deliberately rescued China in 2016 because economic “blowback” from its currency crisis was hitting US shores. This time China is the collateral beneficiary of US actions taken for other reasons, though the awkward plight of the People’s Bank (PBOC) may have influenced thinking at the market-savvy New York Fed. China’s intractable crisis has reached proportions that are starting to frighten everybody.

The PBOC has until now been loath to loosen monetary policy for fear of capital flight and pressure on the yuan. This paralysis has allowed the M1 money supply to contract at a 7pc rate and set off an “endogenous deflationary feedback loop”.

Whether China will take advantage of the Fed reprieve is unclear. At a minimum, the chronic haemorrhage of foreign capital through the Shanghai-Hong Kong Connect is likely to stop. Hong Hao from the SiRui Group said the US rate cutting cycle could bring $500bn of overseas investment back into China’s market.

But there is a large caveat to this rosy global picture. It all depends on whether the Fed is ahead of the curve and delivers a soft landing; or whether it is behind the curve, has misjudged the delayed effects of past tightening, and has already let recessionary dynamics take hold.

These binary outcomes can have drastically different consequences for the world.

Mislav Matejka, equity strategist at JP Morgan, says there have been four soft landings and eight recessions in the last 12 Fed cycles. The “softs” delivered stock market gains of 20pc or so over the following year. The “hards” led to months of sell-offs, snowballing into wipeout crashes in 2001 and 2008. This time the starting point is stretched after a 26pc rise in Wall Street’s S&P 500 index over the last year.

Mike Wilson, Morgan Stanley’s equity chief, says part of the stock market has already pocketed a soft landing and pushed the forward earnings ratio of the S&P 500 to 21. But other parts tell another story. “Under the surface, the market has skewed much more defensively. The internals of the equity market may not be betting on a soft landing,” he said.

Bonds are not ratifying the bullish story. Two-year Treasury yields were trading 180 points below the Fed funds rate last week, the widest spread in 40 years and a red alert. “This is the bond market’s way of messaging to the Fed that they are late,” he said.

I do not wish to rain on Jay Powell’s parade but the Fed was forced to act. Its own Beige Book two weeks ago said economic activity was flat or declining in nine of the 12 Fed regional districts, up from five a month earlier.

Professor Tim Duy, Fed Watch founder and chief economist at SGH Macro, said the Atlanta Fed’s instant and stubbornly resilient snapshot of GDP fools a lot of people. The data lags. It is meaningless at inflection points. “If you hold on to the GDP numbers, you will drown,” he said.

The better signal comes from the fragile fringe of the labour market, which always sniffs trouble first. It began to flag pre-recession warnings months ago. Had the Fed known just how fast jobs were cooling, confessed Mr Powell, it might have cut rates in July. He also said the jobs data has become so inaccurate – and so frequently revised later – that the Fed now assumes the true gain in non-farm payrolls to be around 70,000 a month lower than first declared.

Ergo, it is already nearing zero.

My late-cycle signal is the US savings rate, today at 2.9pc and a whisker shy of the pre-Lehman nadir. Levels this low show that large numbers have depleted their savings and are stretched to breaking point. The lower it goes, the more violently it snaps back once fear sets in.

Mr Powell insisted that the economy was “strong overall” but struggled to explain why a jumbo rate cut was nevertheless necessary. “Powell seemed determined to paint a positive view of the US economy. But this does not square with the reality of labour market data.

We disagree with his view that recession risk is not elevated,” said Andrew Hollenhorst from Citigroup, who thinks the Fed may have to cut by more than 50 points at a time.

How this is resolved matters enormously for the world because if the Fed’s tight money policies have already baked in a slump, any short-term rally on Wall Street will soon evaporate and give way to a full-blown bear market. The contagion will spread through the global system and overwhelm all else.

The jury is out on this central question. Astute economists vehemently disagree as they always do when the cycle turns. Personally, I intend to enjoy the Fed party, but not stay too long.