Weekly: Insurance cuts for what?

What are the risks of forthcoming rate cuts by the US Federal Reserve? Less room to cut when a real shock hits; asset price melt-up; policy credibility.
Taimur Baig, Duncan Tan12 Jul 2019
  • The intersection of high debt and high valuation will widen
  • Expect increasing episodes of market tantrum as the Fed put is played out
  • Fed cuts won’t weaken the USD considerably
  • Taking cue from the Fed, major central banks around the world will ease too
  • Weak data out of China and Singapore show mounting downside to Asia’s outlook
Photo credit: AFP Photo

Fed policy and melt-up risks

Federal Reserve Chairman Jay Powell May be secure in his job by constitutional mandate, he nevertheless seems to be doing the bidding for US president Trump. In Congressional testimony (for the semi-annual monetary policy report) overnight, the head of the US central bank could only point to general and tangential risks to the global outlook to make the case for rate cuts.

Absent were any concern on financial instability, unemployment, deflation, wages, or fiscal tightening. Indeed, financial markets are at record highs, unemployment at record low, inflation may be below target but nominal GDP growth is near the highest in the cycle (see chart below), businesses and consumer confidence markers, despite the gloom from trade wars, are only modestly dented.

Against this background, the Fed is reaching for insurance as a hedge toward a weakening global outlook, and the markets are welcoming it. Our concern is two-fold. First, with markets at such heights, and yields already so low, an across-the-board asset price melt-up is a distinct possibility. This will make (if it already hasn’t), differentiation between good and bad companies difficult, leading to likely mispricing of risk and misallocation of resources. At a time when debt stocks are already at record highs, and asset validation has spiked, financial fragility will build up inevitably.

It is not particularly difficult to see the seeds of fragility. Further weakening of the Chinese economy will lead to a powerful waning of demand for exporters of commodities and manufactured goods. Various business plans and asset allocation decisions that were based around continued strength of Chinese demand will therefore be challenged. Cyclical slowdown in auto and electronics demand will weigh in on the outlook, independent of Fed policy.

But the rationale for insurance cuts at this immediate juncture is questionable, in our view. The cushion against above risks can be offered by the Fed only if money market conditions tighten or risk aversion spikes. That is absolutely not the case presently worldwide. Also, as the cycle matures and a slowdown appears over the horizon, the Fed needs to keep ample powder in stock to act vigorously when real risks appear. Insurance rate cuts will reduce that stock prematurely.

Source: Rebert Schiller’s webpage, DBS. Note: Shiller PE ratio for the S&P 500 is based on average inflation-adjusted earnings from the previous 10 years, known as the Cyclically Adjusted PE Ratio (CAPE).

Perhaps the 2020 US elections are a critical subplot. If easing is an imperative, do it the year before elections and stay on the side-line, hoping the insurance cuts to extend the cycle. Such considerations are bound to lead to further complexities and distortions, in our view. Stimulated by the Powell put, the markets will incessantly demand more support after the 2019 rate cuts, in a repeat of tantrums seen in 2015 and 2018. As the Fed’s hand is forced time and again, valuations will get loftier, creating the ground for more volatility and event risks. Watch out.

Taimur Baig

To read the full report, click here to Download the PDF.

Taimur Baig, Ph.D.

Chief Economist - G3 & Asia

Duncan Tan

FX and Rates Strategist - Asean

The information herein is published by DBS Bank Ltd and PT Bank DBS Indonesia (collectively, the “DBS Group”). It is based on information obtained from sources believed to be reliable, but the Group does not make any representation or warranty, express or implied, as to its accuracy, completeness, timeliness or correctness for any particular purpose. Opinions expressed are subject to change without notice. Any recommendation contained herein does not have regard to the specific investment objectives, financial situation & the particular needs of any specific addressee. The information herein is published for the information of addressees only & is not to be taken in substitution for the exercise of judgement by addressees, who should obtain separate legal or financial advice. The Group, or any of its related companies or any individuals connected with the group accepts no liability for any direct, special, indirect, consequential, incidental damages or any other loss or damages of any kind arising from any use of the information herein (including any error, omission or misstatement herein, negligent or otherwise) or further communication thereof, even if the Group or any other person has been advised of the possibility thereof. The information herein is not to be construed as an offer or a solicitation of an offer to buy or sell any securities, futures, options or other financial instruments or to provide any investment advice or services. The Group & its associates, their directors, officers and/or employees may have positions or other interests in, & may effect transactions in securities mentioned herein & may also perform or seek to perform broking, investment banking & other banking or finan­cial services for these companies. The information herein is not intended for distribution to, or use by, any person or entity in any jurisdiction or country where such distribution or use would be contrary to law or regulation. Sources for all charts & tables are CEIC & Bloomberg unless otherwise specified.

DBS Bank Ltd., 12 Marina Blvd, Marina Bay Financial Center Tower 3, Singapore 018982. Tel: 65-6878-8888. Company Registration No. 196800306E.

PT Bank DBS Indonesia, DBS Bank Tower, 33rd floor, Ciputra World 1, Jalan Prof. Dr. Satrio Kav 3-5, Jakarta, 12940, Indonesia. Tel: 62-21-2988-4000. Company Registration No.