Markets Continuously Project Lower Rates...Much Lower
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Several serious questions remain yet to be answered in the aftermath of recent bank failures. While politicians wrestle over who might be to blame, they’ll never come up with a useful answer anyway and far more important is what this will all do to a global system already in rough shape. The possibility of at least recession was already high to begin with before anyone came to know the name Silicon Valley Bank.

China’s reopening had been widely expected to provide some relief and margin for error worldwide. Instead, recent data coming from the country merely confirmed what markets had priced from all the way back in mid-January. There had indeed been a reopening boost though never more than minimal and certainly not something the world’s economy could build off to stave off greater disaster.

I wrote here just two and a half months ago how you could already tell at that early date it wasn’t going well:

“Despite so much radical hype, it isn’t showing up in these places where it really should. As the world’s largest user and importer of oil, an unfettered and legitimately rebounding China economy would have scavenged every last drop of spare oil from the world’s hamstrung crude producers.”

NYMEX’s crude oil futures curve had been in contango from December and prices were, shall we say, softening. Given supply constraints and pitifully thin inventories, WTI should’ve been surging higher and its curve shaped to drastically steep backwardation.

A small bit of backwardation did eventually develop first at the three-month calendar spread on March 22 before the full curve, including the front two contracts, straightened out on April 11. Between those two days, you might remember OPEC delivering its own verdict on China reopening and really global growth prospects when the group announced yet another cut to its production quotas; cuts that became effective just recently, too.

Along with those, Iraq has experienced “issues” as has Nigeria (though for that producer they continue to be many of the same ones). Still more supply problems loom ahead as Canadian wildfires have stranded some output to our North. Bloomberg reported on Tuesday:

 “Shifting fires across Canada’s main energy-producing province are prompting drillers to throttle back production once again — more than a week after the blazes began — and officials are warning of worsening conditions ahead.”

Prices for Canadian oil are higher though almost nowhere else. On the contrary, WTI is moving lower and now back into contango all over again.

It is only the first two contracts but that’s how it always begins. Just a few pennies on Wednesday in spite of the wildfires and the OPEC efforts to stabilize global benchmarks. As of yesterday, contango had reached a full dime when given so many supply woes and low inventories around the world (on water as well as on land) there doesn’t otherwise seem any good explanation for it.

China’s failed reopening offers only a partial one.

It doesn’t take an Ivy League math degree to figure out there will be a negative impact from the banking difficulties the world (not just the US) has already experienced. Not just prospects for some credit crunch, worse an accumulation of factors that could very realistically spiral out of control.

If they do, crude supply would be the absolute least of anyone’s problem. Both demand for oil and the money to trade in it would be greatly diminished, the very properties low priced, contango-compounded WTI represents.

For their part, for whatever it might matter officials at the Federal Reserve concede these rough outlines. The minutes written up from the FOMC’s March meeting, the one conducted in the middle of the first round of banking trouble, said this:

“For some time, the forecast for the U.S. economy prepared by the staff had featured subdued real GDP growth for this year and some softening in the labor market. Given their assessment of the potential economic effects of the recent banking-sector developments, the staff's projection at the time of the March meeting included a mild recession starting later this year…”

The term “mild recession” while it may conjure up memories for something like 2001’s dot-com event or maybe a little more severe like the cycle preceding it, 1990’s S&L recession, it has since been transformed into a positive (of course it has). A small though not catastrophic jump in the unemployment rate which will, some believe, actually help the Fed continue to “fight” “inflation” which those at the central bank continue to say is our greatest risk.

To put it simply and bluntly, officials and their models only ever see limited potential from something like a banking crisis. To begin with, these econometrics straight away assume policymakers will immediately and effectively respond to one, limiting the most troubling aspects and keeping the damage to the economy to a safe minimum.

It is exactly what happened just fifteen years ago:

“MR. PLOSSER. Given that my model is somewhat different from the staff’s model, I continue to believe that monetary policy at its current level is accommodative and that, if this current stance is sustained, the economy will experience faster inflation in the medium term. Clearly, we must pay attention to the adverse effects of the financial disruptions. But we also must recognize that our policy actions today and over the next several months will affect the outcomes of inflation over the medium term. As I said, it is my view that the current stance of policy is inconsistent with price stability in the intermediate term and so rates ultimately will have to rise.”

Before having said this, Philly’s Charles Plosser prefaced his report first by noting, “While a lot of attention in the short run is being paid to financial markets’ turmoil, our decision today must look beyond today’s financial markets to the real economy and its prospects in the future.” If you had to guess when these statements were made, just which FOMC meeting this had been, I doubt you’d correctly identify September 16, 2008.

Yes, the day after Lehman Brothers was announced, a sizable portion of the Fed’s models and voting members were still as concerned about “inflation” risks as they were potential for a recession in their minds could only be a remote and distant future possibility.

This bias would continue ahead well into October 2008, too, as the stock market melted down along with everything else. Even so, all they figured it would amount to was about a percent off GDP. Seriously:

“MR. SLIFMAN. Using our usual method, which we described in the box in Part 1 of the Greenbook, we now think that the intensification of financial stress since the September Greenbook would subtract nearly 1 percentage point from real GDP growth in 2009. The stock market has clearly been a moving target for us as we’ve been trying to put this all together and assess the outlook for next year and 2010.”

This was several weeks after Lehman, AIG, Wachovia, etc. Wall Street was in chaos. The whole world was experiencing obvious distress. No big deal in DC, though.

Robert Rasche of St Louis added:

“MR. RASCHE. The revised forecast from the Board’s staff as of last Friday is for real GDP to be essentially flat for the current and final quarter of 2008. The Macro Advisers forecast from last weekend has flat GDP for the third quarter and a 2 percent annual rate of decline in the fourth quarter followed by weak but positive real growth in the first half of 2009.”

The worst monetary crisis since the Great Recession was thought to become no worse than an exceptionally mild recession. One so minor some policymakers were more concerned they might have to deal with worse inflation in its quickly forgotten aftermath.

You just can’t make this stuff up. Every challenge presents at worst a mild recession in these models.

Having faced no accountability for these errors, the same types of policymakers are still there using the exact same models to tell us today there won’t be too much fallout from another bout of global instability. Obviously, there are differences in intensity now compared to September and October 2008, though that’s only what we’ve experienced thus far.

Even if this ends up being all there is, which is at best a slim chance, I still wouldn’t get too comfortable on Jay Powell’s word.

Markets continuously project lower rates; not just by a little, but by a lot and awfully quickly. That isn’t some Goldilocks minor recession, instead the sort which would make, for example, oil markets completely ignore major and growing supply problems along with incredibly low inventories to shift right back into contango anyway with prices moving generally lower on top.

As unpalatable as it may be, as unthinkable as this will be to quite a lot of folks, the very real and large possibilities of really bad outcomes are only perceived as such on the say-so of official incompetence. Markets aren’t considering a few quarters of flat GDP before a slow recovery just after, but authorities still are and worst they want you to do the same.

The primary lesson here is time. To begin with, we’ve already run out of it. Like 2008, there really isn’t a high degree of uncertainty, rather any ambiguity is an artificial construct of relying on so much bad economics. And it is going to take more time before they get to figure this out, eventually offering rate cuts that will make a few cheap laughs.

“CHAIRMAN BERNANKE. I will just note for the record here that the NBER has finally recognized that a recession began in December 2007. I said in the Christmas tree lighting ceremony that they also recognized that Christmas was on December 25 last year. [Laughter] The Committee was a little more forward-thinking. We began cutting rates, of course, in September 2007 and did 100 basis points of cuts in January 2008. Despite our efforts, this recession, in terms of duration and depth, is likely to be equal to or greater than the two largest previous postwar recessions, those in 1974-75 and 1981-82.”

Far from forward-thinking as Bernanke tried to claim, having continuously downplayed the risks and relied on the belief rate cuts were some powerful economic answer, “somehow” in the end the entire world and not just the US suffered worse than the worst postwar recession.

Something like that couldn’t possibly happen again, right? Now that’s a laugh.

Jeff Snider is Chief Strategist for Atlas Financial and co-host of the popular Eurodollar University podcast. 

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