Fed relaxes, investors should not

After weeks of turmoil, stock markets around the world appear to be steadying, helped to no small extent by hopes of lower interest rates. This is despite indications that the United States economy, the growth engine for the global economy, is possibly headed for a serious slowdown.

Last week saw most stock markets in the world putting up strong performances. In the US, the Standard & Poor's 500 Index gained 3.5 percent. In Europe, the Dow Jones Stoxx 600 Index rose 4.7 percent. In Asia, the Morgan Stanley Capital International Asia-Pacific Index rose 3.5 percent.

It was not economic data that pushed stock markets higher. Rather it was monetary policy. Or more specifically, monetary policy bias as perceived by investors.

Last week, two central banks, the Bank of Japan and the Federal Reserve, had policy-setting meetings on 20 and 21 March respectively. Both kept interest rates unchanged, as were widely expected. What traders were interested in, though, were the statements accompanying the decisions.

The BoJ's nine board members voted unanimously to keep the overnight call rate target unchanged at 0.5 percent. At the news conference after the meeting, BoJ Governor Toshihiko Fukui gave few clues about the pace of future rate increases but on 22 March he told a parliamentary committee in Tokyo that the central bank would keep rates low for some time and adjustments would be gradual.

The Federal Reserve's decision elicited a more excited response from markets. Why? Because unlike on previous occasions, its accompanying statement this time omitted mention of "any additional firming". Instead, it only mentioned "future policy adjustments".

The US dollar fell and stock and bond prices rose after the statement was released as markets saw it as paving the way for a possible rate cut.

That was despite the Federal Reserve also saying that inflation has been "somewhat elevated" and that "the high level of resource utilization has the potential to sustain" inflation pressures. That incidentally is in line with what I had also written (see "Stocks, hit by subprime turmoil, not getting relief on inflation front").

However, slower economic growth could bring down resource utilisation, and slower growth is exactly what seems to be materialising. Fourth quarter GDP growth was just 2.2 percent and fears that the fallout from the ongoing problems in the subprime mortgage market could drag the rest of the economy further down were not alleviated by last week's housing data, which were mixed at best. Falls in the NAHB/Wells Fargo Housing Market index and building permits in particular raised further doubts that the housing market is stabilising.

Last week also saw the Conference Board report that its index of leading economic indicators fell 0.5 percent in February. In fact, the leading index has been fluctuating between 137 and 138 for most of the past year or so. Such stagnation has in the past more often than not preceded an outright downturn in the index and a recession in the economy.

However, many analysts appear less concerned with the signal that is coming from the leading index than with that from the yield curve.

There are several ways to look at the yield curve. One way is to look at the spread between the yield on the 10-year US Treasury note and the federal funds rate. Another is to look at the spread between the yield on the 10-year Treasury note and the 2-year Treasury note. The accompanying chart shows these spreads and compares them with real US GDP year-on-year growth from 1986 to 2006.


Note that today, the US spreads are negative and, indeed, have been negative for quite some time. This means that the yield curve is inverted, which is often a precursor of a recession.

But perhaps this time is different. The chart also shows the spread between the 10-year Japanese government bond yield and the overnight call rate. This has been much higher than the equivalent US spread, reflecting the easy monetary policy of the BoJ. It means that there is cheap Japanese money available to invest in the US. This keeps US long rates relatively depressed.

Now if US long-term rates have been depressed by an injection of Japanese-funded money, the implication of the negative spread in the US may not be as bad as in previous cycles when the negative spread was the result of a combination of Federal Reserve tightening and a lack of demand for funds.

Having said that, if the US yield curve continues to stay inverted, the message for the economy could be a little more ominous. Over the past year or so, the BoJ has raised its overnight call rate by 50 basis rates. The Japanese spread has narrowed accordingly. The availability of cheap Japanese money is diminishing, so its influence on the US yield curve should also be diminishing.

As it is, the chart shows that the trends and levels of the respective spreads today are close to where they were back in 2000, not long before the US economy went into recession in 2001. That is not a comforting thought.

Possibly Federal Reserve officials feel uncomfortable too. Uncomfortable enough to contemplate "future policy adjustments" last week.

Investors probably should not get too comfortable either. A relaxation in the Federal Reserve's tightening bias does not necessarily translate into an imminent rate cut.

And even if it does, today's parallel with 2000-01 provides another uncomfortable thought. Back then, the Federal Reserve began cutting interest rates at the start of 2001, about nine months into a bear market; the stock market did not bottom until almost two years later.