Another Downturn Would At This Point Be Devastating

Another Downturn Would At This Point Be Devastating
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Go back one year. On June 13, 2018, the FOMC voted to raise the federal funds range by another quarter percent. By every account in the mainstream, this was consistent with how we were told the economy was progressing. The labor market was on fire and so was the economy, they said. Two months earlier, the Wall Street Journal wrote:

“About a quarter of economists surveyed by The Wall Street Journal now expect Federal Reserve Chairman Jerome Powell to pursue a more aggressive pace of interest-rate increases than his predecessor, Janet Yellen, following U.S. moves to cut taxes and boost government spending.”

It was winning on all sides. The federal government had finally delivered to Economists the thing they long for most – fiscal stimulus. The very stuff of neo-Keynesian fantasy, a large dose of tax cuts along with continued deregulation (including many of the elements, like the health insurance mandate, which some political Economists had said were primary causes of so much of the prior lethargy). How could it possibly go wrong?

A little over a month after the June rate hike, the Bureau of Economic Analysis reported that in its preliminary estimate for Q2 real GDP the US economy had advanced by better than 4%. Confirmation to many of at long last an actual boom.

During those happy-go-lucky middle months of 2018, what if someone had told you that in all of 2019 not only would there be no further rate hikes, the only moves the Federal Reserve would make would be rate cuts? And not just one, but likely several. You might have been more open to the idea, but in the mainstream it was laughable. Totally impossible.

And yet, it wasn’t just “someone” who was saying this. The same day the FOMC gathered to vote for that June hike, the eurodollar futures curve inverted for the first time. In the middle of the “boom”, right at the apex of what was hawkish mania.

The slight inversion amounted to a serious if ultimately unheeded warning. The chances of not just the Fed but the whole mainstream forecast making a substantial error had become very high. This market along with the flattening US Treasury yield curve was telling the world to take a minute and really make sure first before jumping off Jay Powell’s inflationary bridge.

Even the 4.1% GDP was less impressive. People keep forgetting we’ve seen 4% quarters before. They weren’t totally absent during the malaise just way too infrequent. In the middle months of 2014, there were two in a row not that it made any difference.

The message behind the flat curves before June 2018 was how the biggest, deepest market in the world was telling anyone with an open mind there was trouble brewing. It only started with a seriously isolated unemployment rate and the lack of inflationary confirmation for it. What was really on the minds of “bond traders” was the potential for yet another monetary break.

Liquidity risk, in the parlance of the realm.

It showed up on May 29, 2018. Thus, what was flat and worried curves became those featuring more and more conviction – these policymakers have it all wrong again.

The signals were not missed in Washington. Shocking, I know. In early July last year, the FOMC published the minutes of that June policy gathering. In them, there was a passage related to the yield curve and how US Treasury rates were not in keeping with the agreed-upon sentiment about the economy. Short version: if the economy is so awesome and going to stay that way, why is the yield curve flattening so much?

This account of the policy meeting is a sanitized and truncated version of real and often lengthy discussions. In the minutes, what appears to be the majority wanted to make sure to get across their message that the bond market must be wrong. We know this because some detail for it was added to the final output, what was released to the public.

They came up with excuses like R* and, as always, term premiums.

And yet, there must also have been a determined minority; one which demanded at least some mention of a disagreement on this topic. For a policymaking body that often demands uniformity and conformity, it speaks to serious unease. Here’s what the text says about it:

“Some participants noted that such factors [R* and term premiums] might temper the reliability of the slope of the yield curve as an indicator of future economic activity; however, several others expressed doubt about whether such factors were distorting the information content of the yield curve.”

A true economic recovery, a real one in fact not just in narrative, would be received first and foremost in the bond market. And by bond market, I mean much more than just US Treasuries. A paradigm shift after a decade of substantial weakness would have translated into other sovereign debt markets as well as into other parts of the US$ system.

Accompanying a huge, blow-your-head-off bond massacre we would’ve seen swap spreads normalize – meaning interest rate swap prices moving out of the negatives or near zero spreads and shooting upwards to sixty, seventy, maybe even 100 basis points above those skyrocketing Treasury rates. All the big curves would’ve gone almost vertical, not horizontal.

None of those things were happening; none of the market indications were even hinting in that direction. Even during the “best” of the boom in early 2018 these markets were at most saying, “the mainstream narrative isn’t impossible.”

After May 29, however, that’s when it shifted back to, “we’ve seen this before.” To put it in Ben Bernanke’s terms, another false dawn, the third in a string of them. This possibility seems to have registered in that minority as entirely too familiar - beginning with the contrary case staked out yet again by the yield curve.

And it is exactly what has unfolded and what unfolds before us still. The rate cuts haven’t started yet, but the market is now saying, “soon.” Not only are eurodollar futures prices through the roof, and for contracts in 2019, even those expiring in the next few months, Treasury bill yields are plummeting. I made a big point of them last week, especially the 4-week instrument. The front bill is ten basis points lower right now than when I last wrote about it.

The July 2019 eurodollar futures contract, for instance, is currently priced at just about 97.72. Three-month LIBOR, the money rate which eurodollar futures reference for final payout and settlement, has been falling again – just as the curve has forecast with its inversion.

On May 30, this benchmark money rate was fixed at 2.52025%. As of the last posted result, 2.42788%. A drop of more than 9 bps in nine trading sessions. It doesn’t sound like much, but like T-bill yields it is a huge change.

And the whole eurodollar curve says it’s going to keep on going lower and lower. Right now, by the July contract, LIBOR should be somewhere around 2.28% when it drops off the board (matures). If that’s what ends up happening, and the curve has been spot on all year, that puts 3-month LIBOR twenty-two basis points below the upper bound of the federal funds target range and only three basis points from its lower bound.

A growing probability of a rate cut maybe not next week but possibly next month.

The next contract in line, August 2019, is currently priced around 97.85. This implies a 3-month LIBOR rate around ten basis points below the current lower bound. By the time you get to December 2019, the market right now expects 3-month LIBOR just about 1.95%. And that’s just if you take contract prices literally (they are actually a probability spectrum beginning with that number).

FOMC officials agree today that this could happen. But that’s largely the point, and it is not their point. How could they get this so wrong? In one year’s time, boom and aggressive rate hikes have become some number of rate cuts of an undetermined nature. What was thought impossible is now the best-case scenario.

Chairman Powell has said that any rate cuts the Fed might consider would amount to nothing more than insurance for this boom to continue. How would he know what they are? The implications of a false dawn begin right in his models and conjecture.

That’s all this boom ever was; conjecture. Follow the bond market in both directions; forward to better understand what is happening today and what that might mean for tomorrow. Also, backward to get some sense of how we got to this point when “everyone” said there was no chance it could end up this way.

The bond market mispriced nothing. The media overpriced Powell just like it overpriced Yellen (and way, way overpriced Bernanke).

The economy is facing serious trouble at a time when it cannot afford any. Another downturn or, following the curves, worse would be devastating. To suffer yet another big setback before that recovery paradigm shift, before the liftoff and end to the malaise; think about what the last downturn did in terms of the election(s) of 2016. Expand that thought to populists and socialists globally, gross and active dissatisfaction more generally.

The Fed got it wrong. The tax cuts and deregulation weren’t the answers, either. What is left that keeps leading the economy astray just at the moment it seems poised to escape? How this is unfolding in 2019 is in general terms not all that different from how it went in 2015 or 2012.

Sweeping aside term premiums, which the bond market itself is doing a good job the lower yields fall, Economists have only R* to hold on to. But it’s not the safety blanket they make it out to be, the get-out-of-jail-free card pointing the finger at you and me. It is a distraction purposefully cloaked in hands-off mathematics.

R* or R-star is their conception of a natural interest rate. In convention, a low natural rate suggests there is something wrong with the economy itself. There are structural problems which hold back what otherwise might seem normal growth potential. The Fed gave it everything it had, but supply side considerations in investment as well as labor thwarted genius.

Here’s FRBNY’s John Williams in 2017 when he was then President of FRBSF:

“This isn’t just affecting the U.S. economy – lower r-star is a global phenomenon. In fact, the average r-star in Canada, the euro area, Japan, and the United Kingdom is a bit below 0.5 percent. A variety of factors have pushed r-star to this low level, and they appear poised to stay that way. The major one is that the sustainable growth rate of the economy has slowed dramatically from prior decades.”

Why? To the Economist today, Baby Boomers and drug addicts. Williams went so far as to add another factor to the list last week, how people living longer tended to “hold back productivity and thus keep the U.S and other developed economies in a low-growth pattern.” I’m not making this up; these really are unserious people leaving the world to face the very serious consequences of getting all this stuff wrong.

What Williams won’t tell you, what no Economist will voluntarily point out, is how even R* provides us with a huge clue. But recognizing and following that clue would lead central bankers to look squarely in the mirror. They’ll instead tell you about how the natural rate has been falling for a very long time. This isn’t something new, it’s been in the works for decades. And it’s happening everywhere, not just here.

All that is technically true. And yet, by every mainstream measure of R*, whether it’s a real thing or not, they all show the same big point – the bulk of its drop, the vast majority takes place in 2008! Funny how that’s never mentioned.

It’s as if some huge worldwide phenomenon punched a hole in global economic potential in a very short period of time, all coinciding with something absolutely colossal that might’ve showed up out of nowhere around 2008. The list of things that could possibly explain all the facts is exceedingly small; in fact, there is only one item on it. And it’s neither retiring Baby Boomers nor increased lifespans.

Going back to Williams in 2017:

“While a central bank like the Fed sets short-term interest rates, r-star is a result of structural economic factors beyond the influence of central banks and monetary policy.”

Given the way in which interest rates, even money rates, have developed over this last year, does the Fed even set the short-term interest rate? Maybe at some times. But if not the Fed in other times, then what?

The “structural economic factors beyond the influence of central banks and monetary policy” might include those very rates, some shadow mysterious of a random error in econometric models. Like retiring Baby Boomers, in the mainstream conception of R* the eurodollar system also lies outside of monetary policy’s boundaries. For someone like John Williams or Jay Powell, it would look like the same thing. An unknown.

The problem with preventing what are otherwise very smart people from making this connection is pure ideology. I think some policymakers and some Economists know it. They can’t keep saying the bond market is wrong, like they did in 2007 dismissing all these very same signals, and have it turn out to be right time and time again.

But to admit 2008’s role in even R* would be to admit how badly they botched it; like this measure of potential and the trajectory of interest rates, nothing has been the same since the ugly fall. It has proved to be a real inflection point in every way imaginable, leaving the public with a very different image than heroic fighters saving the whole world from a worse fate.

And turning in that direction, the entire discipline would be open and subject right away to very harsh questions about how that could ever have happened in the first place.

They had one job to do…

Jay Powell is not about to hold a press conference at any point during his tenure to fess up to the dirty little secret of central banking. There is, and has been, no money in monetary policy; the one thing that might’ve been handy during the only monetary panic of the last four generations. To monetary authorities, money is that unknown. There just aren’t any circumstances where they can act on this fact.

Upon hearing the truth, I suspect the vast majority of the world would react with anger, something along the lines of, “what have you been doing this whole time” and “why did you just let 2008 happen and the world suffer the increasing consequences?”

In that way, at least, R* and the curves are consistent and very much the same thing approached from different angles (try plotting R* against the 30-year swap spread to see what I mean). Nothing whatsoever had changed in 2017 and 2018; R* reflected as much skepticism in monetary policy as the eurodollar and Treasury curves.

While that means 2019 is almost certainly lost, the trick is to catch up before 2020 and beyond is, too. Having wasted all this time in between celebrating another false dawn, going back to what I wrote in April 2016:

“Central banks have proven by their own actions, not their words, that they will only allow ‘their’ recovery which in the end means none. As I have written before, if they were given a choice of maintaining power and control but only leading to more lost decades, or stepping aside and being guaranteed a full and sustainable recovery, they would choose the former every single time.”

In other words, to avoid the entire enterprise’s full and complete discredit they’re going to continue to focus on dealing with the imagined fallout from the Baby Boomer problem we don’t really have rather than face up to the broadly painful possibilities of the monetary one we do. As concise as maybe I could ever be, that sentence is the curves. And, ironically, R*.

Jeffrey Snider is the Chief Investment Strategist of Alhambra Investment Partners, a registered investment advisor. 

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