Rate cuts not a cure to all problems

8 August, 2019

After a 2% slide in US equities early Wednesday, the S&P 500 managed to erase all losses and end up 0.1% higher. Such market reversals have been very rare during the decade-long bull market. As for the reasons for the recovery, there is no one precise reason. For some investors, the S&P 500’s 6.6% drop since July 29 may have looked exaggerated, hence an opportunity to buy bargain stocks. Others point to the steep fall in US Treasury yields which have fallen 22% on the 10-year bonds in just six days, making stocks a better alternative. However, one common factor that all investors seem to agree upon is the expectation of lower interest rates going forward.

Central banks across the globe are rushing to lower interest rates. On Wednesday central banks in New Zealand, Thailand, and India all announce larger-than-expected interest rate cuts. This aggressive approach to monetary policy easing isn’t justified when looking at hard data; however, policymakers seem to be getting prepared for a worsening global economic outlook.

Bets on the Federal Reserve cutting rates by 50 basis points in September are also on the rise. Investors are currently pricing in a 21% chance of a 50 basis point cut in the next meeting. That’s up from 0% last week.

Will lower rates provide a boost to stocks?

In theory, lower interest rates pull down the required rate of return for equities and hence must attract investors to risk assets. However, in the current circumstances, it may not be enough. With no evidence of the trade war abating soon, cheaper credit won’t translate into higher demand from US businesses and consumers. In fact, we may see earnings deteriorating in the next two quarters especially given that the probability of a recession hitting the global economy is now more likely than a month ago.

Presidents Donald Trump and Xi Jinping both know they are playing a very risky game. Trump wants to bring China to its knees as quickly as possible by severely escalating his trade war with Beijing to get a better trade deal. However, the response he has received so far is that China can play a rough game too and still has many tools to use. With this kind of environment, stocks aren’t the best place to park money.

Gold shines as investors seek shelter

Gold prices continued to hold above $1,500 despite the slight recovery in stock markets. With more than $15 trillion in debt trading with a negative yield, there doesn’t seem to be any better alternative to gold. Given that prices have rallied a significant 17% so far this year, expect to see some consolidation now. However, if Trump’s administration considers intervening in the US dollar to bring it down, expect to see another steep rally in the yellow metal price.

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