Investors seem to be betting history will repeat itself, with the Federal Reserve cutting interest rates to keep the U.S. expansion going, just as it did in 1998, producing one final bull run in oil and equity markets.
Between September and November 1998 the Fed cut U.S. interest rates aggressively, with three cuts amounting to a combined 75 basis points, to reverse the economy’s loss of momentum.
Prompt reductions helped to ensure the U.S. economy continued expanding for another 30 months before finally entering recession in April 2001, according to the National Bureau of Economic Research.
Lower rates and continued economic growth subsequently fuelled a remarkable 56-per-cent increase in the S&P 500 equity index over the next 18 months as well as the dot-com bubble.
Reflecting the strong economy, Brent prices more than doubled between September 1998 and August 2000 as oil consumption gains combined with OPEC output restraint and supply disruptions to tighten the market.
Brent’s six-month month calendar spread swung from a contango of more than $2 a barrel in the summer of 1998 to backwardation above $4 by the start of 2000 as excess inventories evaporated.
In 1998, low inflation gave the Fed policy room to offset a deteriorating international economy because of the Asian financial crisis.
By the time the Fed started cutting in September, the U.S. economy had already been expanding for 90 months, which was the third-longest expansion on record at the time.
Unemployment was at 4.6 per cent, the lowest for a quarter of a century, while core consumer prices excluding food and energy were rising at 2.8 per cent a year (both close to current conditions).
Late-cycle interest rate reductions can provide a very strong stimulus, and the cuts in late 1998 contributed to a renewed surge in activity so strong they were progressively reversed from the middle of 1999.
In the first few weeks of 2019, yields on benchmark 10-year U.S. Treasury notes continue to trend lower and the yield curve is still inching towards full inversion - a sign investors are readying for a slowdown in growth and lower interest rates.
The yield curve is already inverted from one year to three years ahead as bond traders anticipate falling rates in 2020/21.
At the same time, U.S. equity indices and Brent spot prices are pushing steadily higher, implying that the U.S. and global economies will avoid a severe slowdown.
The apparent contradiction between the bearish direction of the bond market and the bullish direction of equity and commodity prices can be resolved by assuming interest rates will peak soon and then fall.
For the moment, investors appear to be betting the economy will slow enough to persuade the Fed to ease monetary conditions, but not so much that it will fall into a full-scale recession.
Most economists polled by Reuters still expect the Fed to raise rates at least once more before the end of September this year.
But more than a quarter expect rates to have been cut at least once by the end of 2020 (“Fed to raise interest rates once more in Q3, then done”, Reuters, March 18).
Even if the Fed chooses to leave policy-controlled rates unchanged, it could ease monetary conditions by reducing or ending bond sales from its balance sheet, or by signalling that it will tolerate slightly more inflation risk.
If the fourth quarter of 2018 was analogous to the fourth quarter of 1998, then the markets are betting 2019/20 will be a lot like 1999/2000 rather than 2001 or 2008.