Economy

Unlock the Editor’s Digest for freeRoula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.R* star is a fun concept (and a fun but now sadly limited-edition T-shirt as well). It is the theoretically “neutral” level of interest rates that doesn’t stimulate or contract the economy, so it’s both a silly construct of economists with physics envy and an influential framework to understand where rates are heading. The Bank of England’s Ambrogio Cesa-Bianchi, Richard Harrison and Rana Sajedi have therefore tried to come up with an estimate for the global economy’s R*, and decompose it into its various components.This matters because . . . . . . Within a standard macroeconomic framework, secular movements in real interest rates are determined by the factors that drive the supply and demand for capital. Over the long run, when capital can move freely across countries, there exists a single interest rate that clears the global capital market. This global trend real interest rate, Global R*, acts as an anchor for domestic interest rates in open economies, so that estimates of Global R* are important inputs to longer-term structural analysis, including the design of policy frameworks. So studying the factors that drive global wealth and capital accumulation is crucial for understanding interest-rate trends around the world.Their stab at this differs from previous attempts which mostly used different models to come up with more real time estimates. Instead, they wanted to look through shocks to see the longer term trend.And as has been widely discussed for years now, they find that R* has been sloping down for decades and remains very low.And here is what they reckon has been driving the secular slump: falling productivity and ageing demographics (zoomable version):This is why the BoE’s economists are sceptical that R* really is rising, as some economists and investors now think. There may be short-term factors that might be lifting it somewhat at the moment, but the big drivers — older, less productive work forces — are not changing, and therefore the long-term trend of falling R-stars is still intact. Further reading:– The fault in R-stars (FTAV) More

Due towards the end of the decade at the earliest, the banknotes are also aimed at reassuring the public that cash is here to stay, even as the ECB works on launching a digital version of its own currency, possibly around the same as it rolls out the new bills. Banknotes under the culture theme could depict monuments, works of art, literature, music, scientific discoveries and inventions. The nature theme could show rivers crossing borders or depict images of regional birds. “They both share a common thread of connecting Europeans and this is what Europe and our common currency is all about: connecting us,” ECB President Christine Lagarde said. A final design could be chosen in 2026 while it could take another several years before they are actually issued into circulation.The new banknotes will replace the more than two decade old design of windows, gateways and bridges. The changes do not impact coins, which feature national designs. More

LONDON (Reuters) – Public pension and sovereign wealth funds managing $4.3 trillion in assets are pessimistic about investing in China, but keen to cut net emissions of their portfolios, according to a survey by the Official Monetary and Financial Institutions Forum (OMFIF). The survey of 22 funds by OMFIF, a think tank for central banking, economic policy and public investment, also showed that 62% of the 50 largest pension funds and nearly half of the largest sovereign wealth funds suffered losses last year amid high inflation and historically rapid global rate hikes. OMFIF outlined a dark mood among the funds, with more than half expecting a global economic recession in the next 12 months. None reported a positive outlook for China’s economy, citing the regulatory environment and geopolitics among primary factors dissuading them from investing. The world’s second-largest economy is struggling to boost growth amid a debt-laden real estate sector and consumers who are looking to save more due to the economic uncertainty.”India is the most attractive emerging market among respondents, while the majority identified regulation and geopolitics as hurdles to investing in China,” authors of the report launched on Thursday found. The funds remain worried about interest rates, the survey showed, with 63% citing them as the top factor in their investment strategies over the coming decade, double the share from last year’s survey.”(Investors) are now focused on how to deal with a macroeconomic environment that is stuck in a higher-for-longer interest rate cycle,” the report said. While 73% of the funds said they have a pledge to achieve net zero emissions in their portfolio by 2050, and more than a third planning to increase their allocation to green bonds and green real assets in the next 12-24 months, any investments still need to make money for the funds. “We’re looking for deals where there is a meeting of ESG and returns, and we don’t accept lower returns just to comply with ESG targets,” David Morley, managing director and head of Europe at Caisse de Depot et Placement du Québec, said in the survey. Overall, sovereign funds fared better than their public pension peers, OMFIF added. Aggregate assets under management of the top 50 sovereign funds edged 2.3% higher to $11.6 trillion from $11.3 trillion a year before, helped by outsized gains in Middle East funds as they benefit from the surge in commodity prices. The UAE’s Abu Dhabi Investment Authority and Saudi Public Investment Corporation grew by 13.8% and 12.9% respectively, gaining over $200 billion between them. More

ORLANDO, Florida (Reuters) -If cash has been king, the Fed may be plotting regicide. As the Federal Reserve’s policy ‘pivot’ draws into view, investors face a $6 trillion question – where to deploy this record amount of cash if the beefy interest rate returns drawing people there evaporate again?Earning short-term rates not seen for well over a decade, the attraction of 5% cash is considerable and raises a high bar for other assets to perform in such an uncertain economic environment. But once the first Fed cut comes into view, that money will move rapidly out the maturity curve and into riskier assets. Doubly fast if, as is consensus, those cuts arrive without being forced by recession. And the scramble to lock into high long-term coupons could quickly become a stampede. Fed Governor Christopher Waller this week gave the strongest hint yet that the first Fed cut may be closer than many had been anticipating, and rates and bond traders have reacted swiftly.Rates futures markets are now pricing in more than 100 basis points of cuts next year starting in May, and the two-year Treasury yield is its lowest since July – it has slumped 35 basis points this week alone.A recent report by BlackRock (NYSE:BLK), the world’s largest asset manager, notes that on average, cash returns 4.5% in the year following the final Fed rate hike, significantly underperforming a wide array of asset classes.This becomes particularly acute once the Fed actually starts cutting rates, as the opportunity cost of owning an asset whose nominal and real returns are dwindling relative to other asset classes is magnified even further.Emerging market debt, U.S. equities and dividend stocks are investments which, on average, provide the juiciest returns of 20% or more in the 12 months after the Fed’s last rate hike, the BlackRock report finds.”Clients should be deploying cash into assets that are consistent with their base case scenario for 2024,” says Justin Christofel, co-head of Income Investing for BlackRock’s Multi-Asset Strategies & Solutions group and one of the authors of the report.”There’s a lot of dry powder out there and that can power decent returns,” he adds.MAKE CASH TRASH AGAIN? There certainly is a lot of dry powder. The latest figures tracked by ICI, a global funds industry body, show that total money market fund assets stood at a record high $5.76 trillion on Nov. 21. Of that, $2.24 trillion is in retail investor funds and $3.52 trillion is in institutional funds.That has risen substantially since the Fed started its rate-hiking cycle early last year. According to Bank of America, investors have poured $1.2 trillion into money market funds so far this year. Cash has been investors’ favorite destination in recent years, and with an annual return tracking 4.5%, it is on course for its best year since 2007.BofA’s private clients’ cash holdings as a share of their total $3.2 trillion assets under management is currently 12%, close to the average level over the past 20 years of around 13%. If their wider holdings are representative of investor positioning more broadly, a negative correlation between fixed income and equities could soon emerge.BofA private clients’ share of equities stands at 60% of total assets, above the longer term average of 56%, and their debt allocations is currently 21.5%, below the average 26%. With market-based borrowing costs heading lower in anticipation of official rates being cut next year, many investors will be strongly tempted to lock in yields of 4.5% across the U.S. Treasuries curve now.Those with a more benign view of the economy will be more risk-friendly. Analysts at Goldman Sachs, BofA and Deutsche Bank, among others, see the S&P 500 hitting new all-time highs of at least 5000 next year, while U.S. high yield debt is still yielding more than 8% nominally.Ultimately, fund managers will have to work that bit harder and be more selective, as the easy money from simply parking clients’ investment in cash can no longer be made. “A negative bond-equity correlation paves the way for the only free lunch in finance: diversification,” Robeco’s investment team says.Bridgewater founder Ray Dalio said as recently as last month that cash still holds “relatively attractive appeal,” offering a real return of around 1.5% with no price risk.It might not be long, however, before he veers back towards his bluntly-articulated view from early 2020 that “cash is trash.”(The opinions expressed here are those of the author, a columnist for Reuters.)(By Jamie McGeever; Editing by Josie Kao) More

FRANKFURT (Reuters) – A debt crunch at Swedish property group SBB has left the European Central Bank at risk of losses and highlighted the 26 billion euro ($29 billion) exposure it built up to Europe’s now stricken real estate sector through its crisis-era bond buying.A Reuters analysis of ECB records shows that it owns two euro-denominated bonds issued by SBB, which racked up debts of more than $9 billion buying property, including social housing, government offices, schools and hospitals. Two sources familiar with the matter said that the ECB’s SBB bond holdings totalled a few hundred million euros. One SBB bond is now trading at roughly half its face value, showing investors were pricing in some risk of an eventual debt default.When SBB, which is now junk-rated, recently bought back bonds at a small discount to stabilise its finances, the ECB was among the sellers, one person familiar with the matter said. An ECB spokesperson declined to comment on SBB or any losses incurred, pointing to its website where the central bank characterises its losses in general as “side effects” and says it can dip into large profits of recent years to offset them. Although SBB represents a small exposure for the ECB, it is re-opening a debate about how the euro zone central bank has splashed nearly 400 billion euros on company debt since 2016 as part of huge asset purchases to avert the threat of deflation.In total, it spent around 5 trillion euros on government debt, company bonds and other assets, which it usually holds until maturity. Yet as far back as 2016, the ECB warned of a property bubble in parts of Europe, while at the same time buying bonds in real estate companies in the region under the scheme.”It is hard to understand how the ECB ended up buying the bonds of property companies, while at the same time warning of the risks of property price inflation,” former ECB chief economist Otmar Issing told Reuters. “It contributes to inflating the bubble, while risking its reputation as well as financial losses,” he added.As well as the SBB bonds, the ECB holds debt in other property companies across Europe, including in Germany and Sweden, the countries worst hit after the steepest interest rate hikes in the euro’s history pricked real estate bubbles which had been inflated by a decade of almost free money.SBB’s troubles have been known since early 2022, when it was targeted in a critical report by short-seller Viceroy Research.”They (the ECB) should have applied … active risk management,” said Daniel Gros, director of the Institute for European Policymaking at Bocconi University in Milan. While the ECB outlines the parameters of its bond buying, it does not say how much it bought, at what price or detail any losses. But data this week shows the central bank still owned the two bonds issued by SBB as of Nov. 24.In the event of an SBB default, the euro zone’s 20 national central banks, which share the risk for company bonds bought on the ECB’s behalf under its Corporate Sector Purchase Programme, would have to take a small loss if it still owned the debt, which it bought in mid-2021 and early 2022.”SBB needs to decrease its debt further but has taken significant steps … having repaid 2 billion euros in debt in the last 15 months,” a company spokesperson said. BUYING ‘BLIND’Borrowers from Europe and beyond tapped into the ECB scheme, under which any company, bar banks, qualified so long as its debt was in euros and issued by a euro zone entity with an “investment grade” rating by a major agency.”The purpose was to lower borrowing costs in the euro area and you don’t do that by buying the bonds of a Swedish company,” said Gros, adding that the ECB had “blindly” followed its rules, without taking proper precautions. While Sweden is not in the euro zone, SBB issued the debt bought by the ECB in neighbouring Finland, which is. Alongside the SBB bonds, the ECB also hoovered up the debt of other property companies which have since hit problems, including Sweden’s Heimstaden.Both were downgraded in recent months by Fitch Ratings, which said they were among a handful of European property firms facing “debt maturity walls” in the next 12 to 18 months. The ECB owns eight Heimstaden bonds, issued by an investment-grade-rated unit of the group, including one that is trading at a discount of roughly 40% to its issue price.Heimstaden told Reuters that its finances are sound, that its focus was on “robust liquidity” and investing in its bonds was low risk.The ECB also gobbled up many German real estate bonds, including 39 issued by Vonovia, which has been selling property to cut debt. The bonds trade far closer to par, one at a discount of about 20%.Property companies make up 8% of the ECB’s Corporate Sector Purchase Programme, now worth 326 billion euros. The ECB does not disclose the make-up of its other, pandemic-era bond-buying scheme.The central bank has suffered mishaps in the past, such as when it made a loss on bonds in scandal-hit South African retailer Steinhoff, and posted losses last year, fuelling concern that its capital cushion could shrivel.The ECB outlines several lines of defence against losses, such as staggering them over several years or asking national central banks to chip in.But the Dutch national central bank has warned that it might eventually need a capital increase by its finance ministry, which would likely infuriate taxpayers and raise questions about its independence from politics.”When central banks make losses, it’s ultimately a loss for the government, which means the taxpayers have to pay,” said Gros.($1 = 0.9117 euros)($1 = 10.3532 Swedish crowns) More

This article is an on-site version of our Unhedged newsletter. Sign up here to get the newsletter sent straight to your inbox every weekdayGood morning. GameStop, which has been falling steadily for two years, rose 20 per cent yesterday, and is up 36 per cent over two days. This could be a short squeeze ahead of the company’s earnings report next week, or something to do with options hedging. In any case, higher rates and quantitative tightening have not quite wrung all the speculative hysteria out of the system. If you see others signs of persistent irrationality, email us: [email protected] and [email protected].  Rate cutsThis comment, delivered by Federal Reserve governor Christopher Waller at a think-tank event on Tuesday, generated a fair amount of attention:If we see disinflation continuing for several more months — I don’t know how long that might be, three months, four months, five months . . . you could then start lowering the policy rate just because inflation’s lower . . . It has nothing to do with trying to save the economy.Waller’s comment spurred an immediate reaction in the two-year Treasury yield and the dollar, two markets highly sensitive to the path of policy rates. Both fell.It’s not an unreasonable reaction. Of course, Waller doesn’t set monetary policy by his lonesome. But as Neil Dutta of Renaissance Macro Research notes, he “has been at the front-edge of numerous monetary policy pivots during this tenure at the Fed”. His view is bolstered by the increasing plausibility of a soft-landing scenario.Many investors link cuts and recession — the Fed lowers rates, either proactively or reactively, to support a faltering economy. But as Waller laid out in his speech, there is another path to cuts. Real rates, not nominal policy rates, determine the stance of monetary policy. This implies that as inflation falls, monetary policy will automatically tighten if the Fed holds rates steady. Therefore, rate cuts would serve to keep policy stable, rather than representing a move towards monetary loosening.Waller’s general outlook — that gently falling inflation make rate cuts feasible at some point midway through next year — is catching on. The OECD’s latest economic outlook has the Fed cutting in the second half of 2024. Markets, too, have priced in cuts as early as May. By year-end, they expect rates to fall nearly 100 basis points:This view rests on continued inflation progress, of course. And this is precisely where Fed officials still differ. Most agree that a period of “below-trend growth” is needed to curb inflation, but are we getting that yet? Waller said he was “encouraged” by the slowing pace of growth, which he thinks will come in at about 1-2 per cent in the fourth quarter. But he noted that “just a couple of months ago, inflation and economic activity bounced back up, and the future was looking less certain”.Such caution is shared by other Fed members. One danger is pricing behaviour. Stable inflation discourages price increases, which can lead to loss of market share. But once inflation is elevated, it acts as a co-ordinating mechanism allowing companies to raise prices together. What stops that process is pushback from consumers, making companies worry again about losing market share. But as Richmond Fed president Thomas Barkin told CNBC yesterday:I’m sceptical that price setters at this point are going back to pre-Covid . . . I just don’t know if people are going to give up that power unless they have to . . . I don’t think [recently revised third quarter] 5.2 per cent GDP growth [is] what convinces people they no longer have pricing power.Atlanta Fed president Raphael Bostic, in a comment published yesterday, took the opposite line:My staff and I are picking up clear signals that companies’ pricing power is diminishing. That is, it is no longer easy to raise prices without resistance from customers. In that context, we’re hearing reports of more and more companies sacrificing some profit margin to maintain market share. Firms are increasingly offering discounts and price promotions or otherwise swallowing cost increases rather than risk chasing away customers.It isn’t obvious who is right, looking at third-quarter corporate results. Pricing talk was very mixed. Walmart is talking about the possibility of a deflationary environment, for example; Coke is continuing to increase prices aggressively. Overall, S&P 500 net income margins rose in the third quarter, and consensus forecasts suggest that will continue in the fourth. But big business isn’t the whole economy. The Fed’s Beige Book of economic anecdata, also published yesterday, was stuffed with examples of activity slowing and lower-end consumers pulling back or trading down. The debate is live.All this is to say that despite the soft landing mood in markets, the Fed remains data-dependent. Waller’s cautious case for rate cuts that have “nothing to do with trying to save the economy” is contingent on inflation co-operating, without too much of a slowdown. Markets are betting heavily on that outcome.Against the liquidity theory of the rallyOn Tuesday, we considered the possibility that an increase in financial system liquidity might explain November’s rally. On Wednesday, the macro data analytics shop Quant Insight published a piece arguing that we were barking up the wrong tree. It was bluntly titled “US equity rally — it’s not liquidity”. QI has a factor model that calculates a fair value level for the S&P 500, by applying a statistical technique called principal component analysis to macro inputs including economic growth, Fed posture, the dollar, credit spreads, and so on. PCA is designed to tease out the independent relationships between each explanatory factor and the explanatory target (in the case, the S&P). As of yesterday, the model put fair value for the index at 4,492, 1.4 per cent away from the actual value. The model’s confidence — that is, the amount of the variation in the index that the macro factors are currently able to explain — was 85 per cent.   But QI also has a model of the S&P that includes all those macro factors plus Fed liquidity, and they measure Fed liquidity the same way we measured it in Tuesday’s piece. Using that model, the difference between estimated fair value and the actual value of the S&P was 0.61 per cent, and confidence was 86 per cent. Adding liquidity to the model didn’t add much, in other words. As Huw Roberts of QI sums up: “The improvement in the model’s goodness of fit is marginal . . . Fed liquidity is a positive driver [of the index] but the relationship is modest.”My question, on reading the QI piece, was whether liquidity might be influencing the model covertly, seeping in by influencing other factors such as bond volatility or credit spreads. The central idea of the liquidity theory, after all, is portfolio balance: the notion that changes in liquidity alter investor propensity to pay up for risk. Roberts wrote in an email that the PCA approach, by pulling apart the influence of different factors, helps sniff out this sort of connection, but leaves open the possibility of liquidity influence “leaking” into stock prices through other channels. “To measure that we’d need for example to build a custom model for say US high yield spreads and see whether Fed liquidity features as a prominent driver”.If there are readers out there willing to speak up for the liquidity model, we’d like to hear from you. One good read“It’s got to be one of the deals of the decade.”FT Unhedged podcastCan’t get enough of Unhedged? Listen to our new podcast, hosted by Ethan Wu and Katie Martin, for a 15-minute dive into the latest markets news and financial headlines, twice a week. Catch up on past editions of the newsletter here.Recommended newsletters for youSwamp Notes — Expert insight on the intersection of money and power in US politics. 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Federal Reserve officials are preparing to leave their historic interest-rate raising campaign on hold next month for the third meeting in a row — but that does not mean they are ready to discuss cuts.Since July the federal funds rate has held steady at a 22-year high of 5.25 per cent to 5.5 per cent, a level that policymakers have described as “restrictive” for households and businesses as the central bank seeks to curb demand across the world’s largest economy. But officials have danced around two crucial questions: whether rates are now high enough to bring inflation down to the Fed’s 2 per cent target, and how long they must stay at a “sufficiently restrictive” level.Those questions will remain unanswered when the Federal Open Market Committee convenes in mid-December for the final gathering of 2023. Fed officials are poised to leave open the possibility of more tightening while keeping prospective cuts at bay, even as the economic signals increasingly suggest the debate within the central bank will begin to creep in that direction.The hesitation to officially declare the rate-rising phase of the inflation fight over, and address more directly the parameters for rate cuts, stems in part from concerns that doing so could unleash a wave of looser financial conditions that undermine the Fed’s efforts to rein in price pressures.In one cautionary sign, US stock markets have rallied sharply in recent weeks as long-term interest rates have fallen — something Christopher Waller, a Fed governor, on Tuesday said serves as a reminder that “policymakers must be careful about relying on such tightening to do our job”. That rally accelerated this week after Waller said he was “increasingly confident” that monetary policy was in the right place to achieve the Fed’s goals, and suggested rates could come down if inflation moderates “for several more months”. Now, traders in futures markets wager the first cut will come in May, and that the policy rate will hover around 4 per cent by the end of next year, about a full percentage point lower than its current level.Policymakers are also genuinely uncertain about how quickly inflation will cool and whether the recent string of better than expected data will prove fleeting — as was the case in 2021 — or if consumer price growth will plateau at an unacceptably high level.Thomas Barkin, president of the Richmond Fed, on Wednesday warned that if inflation looks set to “flare back up, I think you want to have the option of doing more on rates”. Jay Powell, Fed chair, also seemed wary earlier this month of again being “misled” by positive news on the inflation front as he kept the door open to more tightening.“I would be very surprised if anytime soon you heard commentary from somebody like the chair or others that ‘we’re done’,” Charles Evans, who retired from the Fed in January after serving 15 years as president of its Chicago bank.John Roberts, who worked for 35 years at the Fed until his departure in 2021, added: “It’s definitely not time for a victory lap.”Still, officials have been unable to deny that the data is starting to suggest they may have done enough to squeeze the economy. Consumer spending has begun to cool alongside business activity across both the manufacturing and services sectors. Demand for workers has ebbed, too, without causing serious cracks in the labour market. Perhaps the most encouraging signal came from the October consumer price index report, which showed annual inflation had moderated to 3.2 per cent — more than analysts had expected — as cost increases slowed.For rate cuts to be considered, officials need to be confident inflation is trending back to 2 per cent in a sustainable way. Powell said earlier this month that officials are not thinking about such policy action “right now at all”.But Powell has previously offered up clues about the Fed’s thinking. He hinted in September that rate cuts could be warranted as inflation moderates, so the central bank’s policy settings do not become more prohibitive. Such an adjustment could resemble the series of cuts the Fed implemented over three meetings in 2019 — which it dubbed a “mid-cycle adjustment” — aimed at mitigating risks to the economy.At minimum, the Fed likely needs to see several inflation reports that reflect a downward trend, as October’s CPI report indicated. For Roberts, now a senior adviser at Evercore ISI, a “headfake-proof” threshold would be core inflation as measured by the personal consumption expenditures price index hitting a six-month pace of 2.5 per cent with wage growth also moving down.“It’s not implausible that by mid-year inflation could be down to where the Fed would be wanting to cut,” he said.A sudden, sharp downturn in activity could also influence the Fed’s approach, although staffers and officials are not expecting that.According to individual forecasts published in September, policymakers predict just 0.5 percentage points’ worth of cuts next year with core inflation cooling to 2.6 per cent, slower growth of 1.5 per cent and a slightly higher unemployment rate of 4.1 per cent. Those estimates will be updated next month. Economists at Deutsche Bank currently forecast the Fed will begin lowering its policy rate in June, bringing it down by a total of 1.75 percentage points by year-end, as the economy tips into a “mild” recession in the first half of 2024. UBS also anticipates the US economy to flatline around 0.3 per cent next year and expects cuts beginning in March. Evans said: “They do have the ability now that inflation has come down that if the economy weakens, they can reposition the funds rate lower but still be restrictive in that environment.“I think they have more policy options if they get into that situation [compared to] if inflation was closer to 4 per cent and they weren’t sure it was coming down.” More