A graph showing today's movements of Japan's Nikkei share average outside a brokerage in Tokyo on Aug. 2.Issei Kato/Reuters
John Rapley is an author and academic who divides his time among London, Johannesburg and Ottawa. His books include Why Empires Fall (Yale University Press, 2023) and Twilight of the Money Gods (Simon and Schuster, 2017).
To listen to market observers, the Federal Reserve is sleeping as the house burns down. After the week began with sharp falls in Asian stock markets, American analysts began calling for emergency interest rate cuts from the Fed. Otherwise, they say, falling stock prices risked turning into an outright crash.
And to many market participants, it sure looked that way when American markets opened on Monday deep in the red. But the truth is that share prices, while down a lot, didn’t quite collapse. The VIX index, a measure of anticipated volatility in asset values, while high, came well down off its peak.
There’s clearly anxiety in markets, but there’s yet to be the sort of massive sell-off that triggers contagion through the financial system sufficient to justify emergency rate cuts.
Those calling for them say it’s not just markets that should concern us. They say that the U.S. economy is slowing so fast it may already be in recession. There’s been much talk over the last few days of the Sahm rule, a measure of the change in unemployment that is used to determine when the economy has entered a recession. Friday’s weak jobs report triggered it, leading many economists to demand the Fed start easing at once.
But the Sahm rule, while popular in markets and respected in central banks, is hardly canonical. There’s been little scholarly work to test it empirically. Moreover, like all statistical measures, it relies on the quality of the data that go into it, which is always problematic with employment data. For what it’s worth, the rule’s inventor, Claudia Sahm, has given her own opinion that the U.S. economy is currently heading toward a recession, but isn’t actually in one.
Arguably, investors are mapping their own pain onto the economy as a whole. Despite Monday’s sell-off, the macro-data from the broader economy doesn’t quite paint the picture of collapse that they’re drawing, at least not yet.
High-frequency data, such as air travel and flight bookings, still indicate a U.S economy that remains in pretty good shape. Although there’s little question the economy has cooled down, it bears repeating that it’s coming off a period of very hot growth. Overall, the picture is of a gradual softening, not an imminent collapse. Consumer spending is still up. The U.S., in short, is not Canada.
Ironically, therefore, the widespread expectation that interest rates will be cut sharply is a self-defeating sentiment. It has driven bond yields down a lot, lowering borrowing costs – the expectation of cuts may actually take the pressure off central banks to get more aggressive with cuts. That is a good thing.
After tripling in value over the last 10 years, U.S. stocks are still priced as if the boom won’t end. Expectations of future earnings presume an economy that will continue growing strongly, making current credit prices, if anything, cheap. Either stock prices must fall further or interest rates will have to go back up before this imbalance is corrected.
The return to the cheap-credit days of the past that many investors seem to now expect may never come. Contrary to expectations, treasury yields fall little during recessions. Meanwhile, expectations of what constitute normal interest rates were shaped by the post-2008 era of ultra-easy money, to which central banks say they won’t now return.
Real rates – the central bank’s rate minus the rate of inflation – were negative during this period. Were that benchmark to be used again – a negative real rate – Canadian interest rates would now be at about 2 per cent. But that won’t likely be where rates end up. Instead, consider that in the period before 2008, real rates averaged about 2.5 per cent, which is only a bit less than where real rates are now.
If central banks were to use those earlier benchmarks, they might cut rates only another 0.25 per cent or so. In truth, given the animated debate under way in central banks about what the ‘neutral’ rate of interest is, they’ll probably land somewhere in between those two levels – lower than now, but not as low as investors currently expect them to go.
The fundamentals therefore suggest that if the Fed were to panic-cut rates, it would only be kicking the can down the line. It could ultimately store up an even bigger panic for the future. For all the talk of the central banks waiting too long to cut rates, the truth is the biggest mistake they made, one that they now acknowledge, was keeping interest rates too low for too long and allowing asset bubbles to inflate.
Now they’re deflating. Provided they continue doing so in what still amounts to an orderly fashion, and provided the macro-economic indicators point to a slowing but not contracting economy, central banks would be justified in their caution as they cut rates.
Investors, including Canadian real estate investors, should therefore probably brace for more of this. Before we see deep and sustained cuts in interest rates, we’ll probably have to see further falls in real prices.
But the markets are not the economy, and investors’ pain is only their own. With the markets running less hot, the economy will benefit since capital, including houses, will become more affordable.