Thursday, February 08, 2018

Stoking a fire with gasoline: why Wall Street shuddered

Why did the US sharemarket suddenly tank?

For the same reason that ours might, one day, although there are no signs of it yet.

The US jobs market is on fire. In the past year the United States has hired an extra 2.1 million workers, and not just because of Trump. In the previous year, under Obama, it hired an extra 2.5 million. All up, since the low point in 2009 the US has taken on an extraordinary 18 million additional workers, an extra 14 per cent.

It has pushed the US unemployment rate down from 10 per cent to 4.1 per cent, where it has stayed for four consecutive months. So low is 4.1 per cent that, with the exception of a few months under President Clinton at the height of tech stock mania at the start of this century, you need to go back to 1969, when astronauts first walked on the moon, to find it bettered.

It's low enough to be well below the official best guess of the so-called "natural" rate of unemployment, below which wage rises fuel accelerating inflation. We've got a so-called natural rate in Australia. The best guess is that ours is about 5 per cent, and, although we have been making in-roads into unemployment, we're not down there yet. The US is down there, well into what would normally be lift-off territory for wages and prices, but here's what's strange: all through 2017 and 2016 and 2015 wage growth scarcely budged. It hasn't moved too far away from 2.5 per cent.

Just as in Australia, without a takeoff in wages there's been no reason to fear a big increase in official interest rates. The US Federal Reserve has pushed up rates five times since the improving US economy allowed it to begin moving its Federal Funds Rate away from zero in 2015, but not aggressively. There has been precious little inflation to contain.

Until Friday. US average hourly earnings per employee jumped, enough to push up the annual growth rate to 2.9 per cent. Inflation, and much higher interest rates to contain it, suddenly became real. The US bond rate (which is the market's best guess of future short-term rates) surged. The 10-year bond climbed to 2.8 per cent, up from 2.4 per cent four weeks earlier.

That's a real cost to any business that needs to borrow long-term, and a real cost to the US government, which will need to borrow big to fund Trump's tax cuts. It means the value of US businesses is suddenly lower, because they are valued with reference to their earnings and the bond rate.

It meant shares were suddenly worth less, because when human traders began offloading shares to reflect the new reality the robots took over, automatically selling to protect themselves. Over two days share prices fell 6.4 per cent. On Tuesday night they regained some of that loss, but the future looks different now; more normal, with the value of shares less likely to keep rising as a consequence of low inflation holding interest rates back.

As popular as they have been with business, Trump's planned tax cuts will have themselves pushed up bond rates. The US government needs to borrow hundreds of billions of dollars more because it isn't fully funding them, in contrast to Australia where the Coalition's tax cuts are meant to be funded by making savings elsewhere and allowing other taxes to remain relatively higher so that company tax rates can be pushed relatively lower.

And Trump's tax cuts will hurt in a more fundamental way. Cutting tax is a great way to boost the economy. If the unemployment rate was 10 per cent it would really help. It would lift the economy without stoking inflation. But when the jobs market is on fire and the unemployment rate is about to hit an unnerving 4 per cent, it will add gasoline and make the flames fly higher.

It'll mean even higher interest rates. Trump is rolling out a policy that should be held in reserve for bad times when times are increasingly good. As the International Monetary Fund noted last month, the US will have to tighten its budget in future years to meet the higher interest costs, perhaps in worse times. It is why it has downgraded its forecasts for US growth beyond 2020. It's the opposite of what's normally regarded as prudent management, which is to borrow when times are bad (as Australia did during the global financial crisis) and to repay when they are better (as Australia is trying to do now).

What it'll mean for us is higher Australian government borrowing rates. Our 10-year bond rate peaked at 2.9 per cent on Monday, up from 2.6 per cent four weeks earlier. All other things being equal, the personal income tax cuts we've been promised have become less affordable.

Trump gives the impression of playing with fire rather than managing it. We don't know where it will lead.

In The Age and Sydney Morning Herald