|11 August, 2019

Monetary easing lifts equities; how about gold?

Policy-wise, in a fast-growing economy the Fed's main goal is to keep inflation in line by raising interest rates

Traders work on the floor at the New York Stock Exchange (NYSE) in New York, U.S., August 5, 2019.

Traders work on the floor at the New York Stock Exchange (NYSE) in New York, U.S., August 5, 2019.

REUTERS/Brendan McDermid

The Federal Reserve has eased more than just monetary policy with its recent policy shift favouring a near-term 'insurance' interest rate cut. The US central bank also eased market fears over a possible global recession by raising expectations that other central banks may follow its lead. Global equity markets saw a short-term benefit from better investor sentiment, supported by the expectation that the world's largest economy may decrease its chances of a serious downturn with a business-friendly interest rate environment. Safe haven asset gold, on the other hand, saw some profit-taking as investors diverted their attention away from the non-yielding precious metal to other opportunities.

The markets' fears may have been eased but they haven't been erased. Parts of the US economy are booming - think oil and gas - and this is driving growth. Other parts, like finance and insurance, sputtered at the end of 2018 before picking up again in the first quarter of 2019.

Perhaps the biggest issue, however, is the anaemic inflation rate. Weaker price inflation may lead to disinflation, which may lead to deflation in the worst-case scenario. If that happens, there is a significant risk of debt defaults because it's more difficult to repay debt when revenues are undermined by lower prices for goods and services. The last time the American economy saw low inflation rates was in 2009 when the average annual inflation rate fell to minus 0.4 per cent and the economy was in a deep recession. The circumstance was partly the result of the US subprime and financial crisis during which debt levels outstripped the economy's ability to repay them.

Policy-wise, in a fast-growing economy the Federal Reserve's main goal is to keep inflation in line by raising interest rates. In a declining economy, the central bank may choose to protect the integrity of bonds with quantitative easing. There's little a central bank can do to boost inflation because that's the role of other economic actors like consumers and businesses. However, at this point these economic actors are cautious about investment and already feeling the effect of trade disputes, judging by the signals coming from the US logistics and trucking industry.

This industry is often the first to feel the pain of economic decline because trade in goods and services plummets. Several major US logistics companies have lowered their earnings outlook and are battening down the hatches for an extended period of uncertainty, for example; US Xpress, Knight-Swift Transportation Holdings and Covenant Transportation Group all cited sluggish freight demand along with excess capacity and inventories as weighing on their revenues.

The heightened awareness of intensified economic risks may be why the spot gold price has slowed its surge but still remains over $1,400 at the time of writing (it breached $1,500 last week). I'm still slightly optimistic on gold given the recent shift in the Federal Reserve's interest rate policy. If there's a continuing decline in the value of the dollar, then gold may retain some upside. Central banks are also pursuing gold and investors are increasing their gold ETF purchases.

With more than $13 trillion worth of global debt trading at yield below zero, it's apparent that the financial sector faces growing vulnerabilities. Overall, the global economy cannot afford a slowdown in revenues at this point. And yet that's exactly what investors are faced with as trade negotiations between the US and China appear to be making little headway.

Adding to global economic woes is an increasingly weaponised US dollar associated with high tariffs, oil sanctions and other volleys on international trade. If President Donald Trump intervenes and changes the current policy on a strong dollar to weaken it - thereby boosting the US economy - a currency war could be triggered with volatile results. The increasing risks to the global economy can be moderated if US-China trade negotiations show substantial progress in the short term. However, one year into the complex trade disputes it may not be realistic to have high expectations of a deal being announced any time soon.

The writer is chief market strategist at FXTM. Views expressed are his own and do not reflect the newspaper's policy.

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