Here it begins, an unofficial start to what will shortly be the mass official exodus from inflation-fighting first transiting through bewilderment before eventually settling in their usual climate of panic. It is as regular as any natural cycle, such as the wildebeests stampeding across the Serengeti searching for green or the Canadian geese flocking by the millions from the looming freeze toward warmer climates.
As any rate hike proponent will tell you, rate hikes require significant stretches and commitment before any presumed impact might be felt. For the Federal Reserve, it hasn’t yet been a full year from when this latest program started. As such, in mid-December, the rate-hiker-in-chief Mr. Powell told the assemblage of only the friendliest of reporters that, “It will take time, however, for the full effects of monetary restraint to be realized, especially on inflation.”
That time was apparently six weeks. This past Wednesday, once more appearing at the head of this ritual masquerading as necessary and transparent communication, Powell’s tone had curiously and clearly softened:
“We can now say I think for the first time that the disinflationary process has started. We can see that and we see it really in goods prices so far.”
Recognize first the important yet hidden qualification between the lines: “we see it.” The last day of January and the first of February 2023 might well have been when policymakers realized what was happening, but that doesn’t at all mean it hadn’t been going down from well before.
By any examination of major price measures, be they consumer, producer, commodity, whatever, a clear shift becomes quickly apparent across nearly the entire lot (a few outliers always excepted). The systemic inflection appears right after June 2022.
The US CPI, for example, had been rising at more than a double-digit pace in the first half of last year. During the latter six months, not even a 1% annual rate. While that may be the most aggressive sample, the results from others show the same if not to that painfully obvious extent.
July or the whole rest of last summer could not have been nearly long enough for even the later aggressive rate hikes to have produced that desired effect. Consider by then the FOMC had only done its third round, and only the first at 75 bps. The upper bound for the fed funds range was just 1.75% at that moment, nowhere close to the “restrictive” territory the committee was seeking.
In mid-November, St. Louis Fed President James Bullard confirmed, “the policy rate is not yet in a zone that may be considered sufficiently restrictive.” The first week this year, Mr. Bullard followed that with, “It now appears that the policy rate will move into the sufficiently restrictive zone during 2023.”
And yet, mid-year 2022 still comes out to have been the top for consumer price acceleration anyway, a fact which is now fair game from those Fed creatures.
What must have changed in this matter of a few weeks?
One possible candidate comes from the marketplace typically scorned by these mainstream discussions. Hardly anyone who pays the bare minimum amount of attention to the yield curve hasn’t heard about inversion. For Treasuries, this recession signal (curve shapes, it needs to be pointed out, are far more useful for a truly wide variety of reasons and circumstances than just this one purpose) first appeared in March 2022 which was actually before the first rate hike in the series (for the record, eurodollar futures inverted back in December 2021).
Those at the Fed including Mr. Powell immediately and confidently dismissed it. Longer-term spreads and forwards are out of favor among Economists and policymakers (same thing). Instead, each turns to near-term spreads particularly those derived from near-term forwards, something called, surprise, the near term forward spread.
Technically speaking, it is a derived calculation of what curves today say the 3-month rate will be eighteen months from now (six quarters ahead). The spread is the difference between that forward and the current 3-month rate. A positive difference indicates the market is pricing the most likely outcomes where ST rates would be generally rising over the term. A negative spread suggests more in the market are thinking rates probably go lower.
In March, this was still wildly steep (+267 bps at its top), therefore rate hikes were deemed appropriate. From there, however, the thing abruptly changed and wouldn’t you know it right in mid-June. At +231 bps on June 13, it crashed to just +35 bps by August 1.
This was also the same moment when the bulk of the yield curve (along with many others around the world) compressed. What had been very modest inversion from March quickly transformed into obvious inversion during that crucial month of July.
Which only raises the question, why would this be ignored? Hardly anyone in the public was made aware.
For answers we need only turn to the usual suspect, Mr. Ben Bernanke.
In March of 2006, the newly-installed Chairman spoke in New York in a speech unfortunately titled Reflections on the Yield Curve and Monetary Policy; unfortunate for the world, even if it worked out really well for the newly-awarded Nobel Laureate. Picking up where his predecessor, Greenspan, left off with the latter’s conundrum, Bernanke said long-term yields just might be too complicated to take at face value unlike the near term forward spread which is uncomplicated, uncompromised, and pure.
Those long-end rates, like today, hadn’t moved nearly so far even though Greenspan then Bernanke consistently hiked short-term rates. By the time the latter was ready to reflect on the subject in March ’06, long yields had already been below short yields in some spots.
The problem, Bernanke asserted, was that longer-term rates can be broken down into demand vs. supply (a common theme right up to today). There could be unrelated factors which affect the fundamentals potentially spoiling the prices of these instruments.
Primary among those, supply itself.
Beyond that, insurance companies, he pointed out, have to hold liquid reserves and prefer something like LT USTs to satisfy various rules and not for expressing any fundamental outlook. Foreign governments and reserve managers in the wake of 1997-98’s Asian Not-financial Crisis began to build up their own stocks of liquid US dollar assets (because it wasn’t an Asian financial crisis, it was a regional eurodollar shortage), likewise choosing USTs and other similar forms (such as GSE debt).
To Bernanke’s credit, he largely rules out that one.
The most likely reason he gave, the Fed. Monetary policy had done such a bang-up awesome job during the “Great Moderation” demand for LT USTs reflected expectations for lower volatility in the economy and markets. Therefore, bondholders required less compensation to hold longer-dated UST assets (lower term premiums).
Before wrapping up his speech, though, Chairman Bernanke did acknowledge there was one teensy, tiny little other possibility keeping rates at the long end down thereby flattening even inverting the curve.
“What does the historically unusual behavior of long-term yields imply for the conduct of monetary policy? The answer, it turns out, depends critically on the source of that behavior…However, if the behavior of long-term yields reflects current or prospective economic conditions, the implications for policy may be quite different--indeed, quite the opposite. The simplest case in point is when low or falling long-term yields reflect investor expectations of future economic weakness.”
Simple and straightforward, yet something policymakers simply refused to consider. Not for any good reason, mind you, as a matter of that very bias and blindness.
The Fed, Bernanke claimed, had engineered that Great Moderation and if it had (the coiners of the term, by the way, were hardly convinced of this) officials must have done so by deploying great skill and finesse developing their models and fine tuning them as required.
“Since that time [from the mid-80s], the volatilities of both real GDP growth and inflation have declined significantly, a phenomenon that economists have dubbed the ‘Great Moderation.’ I have argued elsewhere that improved monetary policies, which stabilized inflation and better anchored inflation expectations, are an important reason for this positive development.”
Would those models which “gave us” that miracle of moderation deny any trouble lay ahead, regardless of any contrary market signal the models’ creators would in unison search for any other explanation that the simple one.
But what if the Fed hadn’t been the reason for all that? This would immediately mean those models were, well, wrong. At the very least, poorly calibrated.
Much of this is why successors to the intellectual emptiness have focused on near-term spreads. They aren’t yet willing to ditch their stochastic calculations for more rational, reasoned, and scientific methods. However, policymakers are indeed aware of, um, limitations. Thus, continued near-total reluctant to embrace the yield curve though pushed to accept one small corner of it.
And still not completely. Right when the October CPI data was released on November 10, the yield curve would collapse even more than it had up to that point. The near term forward spread dropped with the rest, falling an astounded 41 bps just that one day, reaching -4.6 bps and inverting for the first time.
But, remember Bullard, it couldn’t have been enough to sway the FOMC’s stand. The inversion would expand to a range between -35 bps and -45 bps by the time he spoke in early January, again must not have been enough. The day after, however, it dropped like a stone to -73.6 bps and would keep going – with the rest of the global curves – to more than -100 bps!
This level of inversion was and remains substantially more than the worst points during the 2007 debacle (roughly -75 bps). Was that finally enough of a wake up?
We won’t truly know if that’s why the sudden change in Jay Powell’s stance until the FOMC transcripts are released five years from now. You do have to wonder how much the change in January 2023 might have unnerved these suits, strongly indicating to them on their own terms they were about to make the same stupid, needless mistakes.
It isn’t just CPIs dropping off, either. Far more of any concern is economic data globally. While GDP might look great in the US, it did so, too, in late 2007 just before the wheels fell all the way off. A growing list of other macro accounts here and abroad have completely dropped off a cliff, from German retail trade (despite lowered price pains) to just this week ISM’s new orders for manufacturing coming in among the handful of lowest readings in decades.
What markets are and have been pricing is not just the inevitable end to “inflation”, the supply shock. For more than half a year, from the moment when that “inflation” began to turn around, it’s been Bernanke’s “simplest case” which did it only to a degree of severity we haven’t seen since just after 2006.
And if that turns out to be true, among the more visible ways you’d know it would be after the migration from central bank inflation-fighting begins and then becomes the stampede toward rate cuts. Mr. Powell this week said the Fed has no intention of doing them before he quickly qualified his statement, adding “if our outlook comes true.”
Ah yes. The very same outlook produced by the very same models which for decades have blinded and biased these people. In those migrations in the wilderness, it is the blind and biased who get eaten by the predators. Not so here. Rather, like Bernanke, while they fail forever upward the slaughter is left for everyone else.
