A warning from US factories

Unlock the Editor’s Digest for free

Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.

Good morning. The US dollar weakened again yesterday, and (as Robin Brooks of Brookings noted) this happened even as Treasury yields rose, increasing the spreads over other developed countries’ bonds. This is an unusual combination, and suggests global repositioning and hedging of dollar assets is continuing. But perhaps you have a different explanation? If so, email it to us: unhedged@ft.com.

A slightly ominous manufacturing report

The dip in the ISM Manufacturing index, to 48.5 in May from 48.7 in April, was mild (levels under 50 indicate contraction). But as we look at the data more closely, we detect a whiff of stagflation on the goods side of the economy.

The survey showed a big fall in inventories, which could signal an end of companies’ frontloading orders to avoid the price impact of tariffs. If so, it won’t be too long before manufacturers and merchants will have to restock at higher prices, and pass on the increased costs to consumers.

Meanwhile, the employment and new orders indices ticked up slightly but stayed in contraction territory. The prices paid index, while pulling back 0.4 percentage points from April, still clocked in at a feverish 69 per cent. Raw materials prices are still rising fast. Manufacturers highlighted the rise in steel and aluminium prices, even before President Donald Trump doubled tariffs on the two major inputs to 50 per cent from 25 per cent on Friday. Lower energy prices have helped offset some cost pressures on businesses, but this only has so much room to run, Matthew Martin at Oxford Economics points out.

The price index is “consistent with core goods inflation reaccelerating from around zero in April to 2 per cent to 3 per cent later this year”, according to Oliver Allen of Pantheon Macroeconomics. That means the Federal Reserve is also unlikely to come to the rescue of the sector.

Overall, the numbers are softish but not terrible, and manufacturing is a much smaller portion of the economy than services. But the trends are poor, and come at a moment when other soft spots are appearing in a generally solid economy, in areas from housing to durable goods orders. Someone bring us some good news, please. 

(Kim)

Quantitative easing by bank

Last week we wrote about proposed reforms to the supplementary leverage ratio, which would allow US banks to hold less capital against Treasuries. But we didn’t talk about the implications for inflation and the money supply, which matter. 

New money is mostly created by commercial banks. When they lend, they create money in the form of a deposit in the borrower’s account. The bank’s balance sheet increases on both sides: the new deposit liability and a new loan asset. Some economists have argued that bank capital rules, such as the SLR, slow commercial bank money growth. Here’s Steve Hanke of Johns Hopkins:

In the 60 years prior to the great financial crisis, financial assets in the banking system were growing 7-8 per cent a year. What has happened since the GFC . . . the growth in financial assets in the banking system has shrunk, and averaged 4.4 per cent growth per year . . . [Because of regulations like Dodd-Frank and Basel III] banks stopped extending as many new loans, and were not rolling over old loans . . . That is why we had quantitative easing . . . the Fed stepped in to mitigate the damage that had been done by the regulations, because money supply growth had been slowing.

It is possible that, were the SLR requirements loosened, banks would simply buy more Treasuries. But the banks could also put the freed-up capital behind new loans, leading to more economic activity. Brian Moynihan, CEO of Bank of America, says this is what would happen in a recent call with investors:

The SLR requires us to hold capital at a level against riskless assets and Treasuries and cash. That doesn’t make a lot of sense . . . [reform] will help us provide liquidity to our clients, both in good times and times of stress. Our cash and government-guaranteed securities and government-issued securities is $1.2tn of our balance sheet right now. So think about capitalising that under the SLR at 5 per cent or whatever it is, and that’s a big number.

Many observers (including several conspiracy-minded Unhedged readers) believe that SLR reform is quantitative easing by other means. If it leads to banks holding more Treasuries, it would depress yields; if it led to more lending, it would provide an economic stimulus. Both would add to the money supply.

But there are important differences. To the degree SLR reform incentivises bank Treasury purchases, it will probably mostly affect short-duration Treasury yields, as opposed to the benchmark 10-year Treasury yield, due to banks’ preference for buying shorter-duration securities and the Treasury’s present preference for issuing them. And the 10-year yield has an important link to the real economy because it helps determine (among other things) mortgage rates.

And bank Treasury buying will not sway the Treasury market in the same way as Fed buying, says Joseph Wang at Monetary Macro:

When the Fed does QE, they are essentially saying to the market: “We will buy $100bn a month.” The Fed doesn’t care what the rate is when they do that. But if banks were to do this they would be more discretionary. There would be no rule about $100bn a month. They would buy more opportunistically . . . meaning the interest rate impact would be smaller.

Remember, as well, that banks’ commercial lending decisions are determined not just by capital roles but by the economy. They will only lend when there are creditworthy companies that need more credit. Regulators can’t create more of those by fiddling with a ratio.

(Reiter and Armstrong)

Two good reads

Tacos económicos y tacos politicos.

FT Unhedged podcast

Can’t get enough of Unhedged? Listen to our new podcast, 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.