In reaction to the sharp deceleration in the expected economic activity, emerging market central banks have also engaged in expansionary monetary policies, totaling a net 14 rate cuts in August (for a group of 37 EM countries), the largest number since the financial crisis. We recently saw Societe Generale's global leading economic indicator, which is a news flow indicator built for a total of 42 EM and DM economies, falling well below the 50-line threshold which separates growth from contraction, and is pricing in much further deceleration in the global economic activity (figure 1, left frame). The global manufacturing PMI index built by JPMorgan also showed a similar post-crisis pattern and has co-moved strongly with the US 10Y in the past cycle (figure 1, right frame). With the US ISM PMI falling below 50 this month (49.1 vs. 51.1 expected), we will see if the negative trend will continue in the coming months, which would imply lower global yields as the probability of a global recession will eventually approach 100%.
The next Fed meeting is taking place on September 17/18 and a few market participants have been speculating on a large 50bps cut. The implied probability of a large cut is currently very low (less than 10% according to the CME FedWatch Tool), and we mentioned that Powell could actually send the market the wrong signal by cutting 50bps, which would generate an equity sell-off as investors would fear that something more important is actually happening. A large cut would definitely contradict Powell's May speech on the business cycle and corporate debt in which he mentions that the current economic cycle stands in the middle of "this is a return of the subprime mortgage crisis" and "nothing to worry about here". In addition, a 50bps cut would give Trump a massive favor after all the tweets calling for rate cuts.
Even though most of the market participants are blaming the uncertainty around the trade war to be one of the most important factors behind the deceleration of the global economic activity, we also need to emphasize the negative impact of the 225bps rate hikes in addition to the USD 800bn of quantitative tightening (QT). Empirically, it is known that QT has a lagging effect on real GDP growth, and that policymakers may have not realized the implication of tightening too much too fast. Economists have calculated that the Fed would have had to cut interest rates down to -3% if policymakers did not increase the size of the central bank's balance sheet (figure 2, left frame). Every USD 300bn of purchases was equivalent to a 25bps cut according to Wu-Xia calculations. Hence, if you include QT, the Fed hiked by 525bps in the past five years, which is empirically significant (Fed hiked by 425bps in the previous cycle between 2004 and 2006) and has usually impacted the economic activity.
The problem that we have today is that if the situation persists and central banks continue to cut rates aggressively, this scenario has usually been bad for stocks. If we compute the GDP-weighted G7 policy rate, we can notice that each time central banks cut rates aggressively, equities have plunged. Even though price volatility has been rising in recent months with the VIX averaging more than 20 in August, US equities have remained resilient and have been flirting with the 3,000 resistance. However, more rate cuts could eventually send a panic signal to the market and kick off another important sell-off in the coming months.
Disclosure: I am/we are long GBP. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.