Posts tagged Us Macroeconomic Data
Here’s a quote from a mainstream media fixture. How recent is it? “Financial markets have soared during the last month on expectations of a cut in rates. The Federal Reserve’s top officials…may have grown increasingly reluctant in the last several weeks to risk causing turmoil on Wall Street by leaving rates unchanged, analysts said.”
That little blurb from a New York Times article certainly sounds like it could have been written sometime within the past, oh, forty-eight hours. In fact, that article came out on July 7, 1995, two days after the Alan Greenspan Fed cut interest rates for the first time since 1992 (the article’s subtitle “Stocks and Bonds Soar” of course would be no less appropriate for anything written during the week ending June 21, 2019). The 1995 event was a particular flavor of monetary policy action called an “insurance cut,” and it has some instructive value for what might be going through the minds of the Powell Fed today.
Anatomy of an Insurance Cut
In the chart below we illustrate the context in which the 1995 rate (and two subsequent cuts ending in February 1996) took place. What we think of today as the “Roaring ‘90s” had not yet gotten into gear (in fact it was just about to start with the initial public offering of Netscape, the Internet browser, just one month after the Fed’s rate cut). In July 1995 the Fed had just capped off a series of seven rate hikes that had begun in 1994 and that had taken the stock market by surprise. Core inflation had crept back up above three percent, and a handful of economic indicators warned of a potential slowdown.
Despite the upturn in inflation, many observers at the time – on Wall Street, in corporate executive suites and in the Clinton White House alike – complained that the Fed’s rate hike program in 1994-95 had gone too far, too fast. Politics were certainly part of this mix, summer 1995 being a bit over a year away from the next presidential election (stop us if you’ve heard this one before). While the headline numbers didn’t suggest that a recession was imminent, there were indications that business investment had slowed with a build-up in inventories. The index of leading indicators, often used as a predictive signal for a downturn, had come in negative for four consecutive months. In announcing the rate cut, the Greenspan Fed emphasized that this move was more about getting out in front of any potential downturn, and less about the looming imminence of such a reversal.
Again, any of this sound familiar?
It’s a Different World
Equity investors, of course, would dearly love to imagine that a Fed insurance cut policy will always lead to the kind of outcome seen in the latter years of that chart above; namely, the stock market melt-up that roared through the late ‘90s and into the first couple months of the new millennium. Such an outcome is certainly possible. But before putting on one’s “party like it’s 1999” hat, it would be advisable to consider the differences between then and now.
The most glaring difference, in looking at the above charts, is the vast amount of blank space between the Fed funds rate and inflation. Yes, there was positive purchasing power for fixed income investors back in those days. Moreover, the US economy was able to grow, and grow quite nicely, with nominal interest rates in the mid/upper-single digits. This was real, organic economic growth. Yes – it’s easy to conflate the economic growth cycle of the late 1990s with the Internet bubble. But that bubble didn’t really take off until the very last part of the cycle – and in actual economic terms, Internet-related commerce was not a major contributor to total gross domestic product. This was a solid growth cycle.
The Greenspan insurance cuts, then, were undertaken with a fairly high degree of confidence in the economy’s underlying resilience. Today’s message is starkly different. What the market and the Fed apparently both conclude is that the present economic growth cycle cannot withstand the pressure of interest rates much or at all higher than the 2.5 percent upper bound where the Fed funds rate currently resides (and forget about positive purchasing power for anyone invested in high-grade fixed income securities). It’s a signal that, if the economy does turn negative, then central banks are going to have to get even more creative than they did back in the wake of the 2008 recession, because a rate cut policy from today’s already anemic levels won’t carry much firepower.
For the moment, the mentality among investors is optimistic that a best-of-all-possible-worlds result will come out of this. Dreams of a late-90s style melt-up are no doubt dancing in the heads of investors as they shovel $14.4 billion into global equity funds this week – the biggest inflow in 15 months. But no two bull markets are alike, and that goes for insurance-style rate cuts as well.
Well, we’re 22 trading days into the pullback that started after the last S&P 500 record high set on April 30. That’s 123 fewer than the 145 trading days it took for the last pullback to regain its previous high, from September 2018 to April 2019. Which, by the by, was exactly the same number of market-open days – 145 – that it took the January 2018 correction to regain its former altitude. Interesting for those who like to read meaning into randomness, perhaps…But we digress! Because, yes, the S&P 500’s retreat of more than five percent from that April 30 high has the usual red lights flashing all across the CNBC screen and Dow point drops (always point drops, always the Dow, so much more dramatic than the more mundane percentage creeps) juxtaposed next to the head of a speechifying Robert Mueller. But the real story this week is in the bond market, and specifically the strange shape of the Treasury yield curve.
The Yield Scythe
The chart below shows the evolution of the Treasury yield curve’s shape over the past month and compares it to what a more normal curve looked like one year ago. The blue line represents the most recent configuration of the curve, which looks like nothing more than a scythe ready to attack a field of wheat. Or a Marxist sickle missing its hammer, perhaps.
We’ve talked about the yield curve in these pages before, of course. The shape of the curve is important because an inverted curve – which is what is currently happening between short and intermediate term maturities – has historically been an extremely reliable predictor of recession. Every recession in the past sixty years has been ushered in by an inverted yield curve (though the timing between a curve inversion and the onset of a recession is subject to high levels of variance).
Do the Math
The relationship between the yield curve and the economy is not complicated, as bond math is entirely straightforward. Yields drop when prices rise, and prices on low-risk securities like US Treasuries rise when investors seek safe havens from riskier assets like stocks. When intermediate yields drop, it can signal the assumption by investors that central bankers will be pushing down short term rates.
Right now the Fed funds rate – the overnight lending rate between banks that the Fed effectively controls through its open market policy operations – is within a target range of 2.25 – 2.5 percent. You can see that short term Treasuries, which tend to move more or less in sync with the Fed funds rate, are all bunched around the middle of that target range, while the intermediate maturities of two to ten years all trade below the floor of the Fed funds range. In many ways, this is just a visual confirmation of what we already know to be true from other data sources like the Fed funds futures market. Bond investors expect at least one, maybe two, rate cuts before the end of the year. In other words, they look into the future and see a Fed funds target range with a floor as low as 1.75 percent – and where the Fed funds rate goes, those short-term Treasuries will follow. Then the yield curve would revert to something more like a less-steep version of that yellow line on the above chart.
But Where Is the Evidence?
The one missing piece in this puzzle is…well, actual evidence. Recall that we have just posted the lowest unemployment rate – 3.6 percent – since 1969. Real GDP growth remains positive, if not necessarily going gangbusters, and while corporate earnings have decelerated from the tax cut-fueled high of 2018, businesses’ top line sales continue to grow at a healthy pace – over five percent for Q1 of this year with almost all S&P 500 companies having reported. Low inflation continues to perplex the Fed. But the core personal consumption expenditure (PCE) index, the Fed’s preferred inflation gauge, also stayed below two percent for most of the second half of the 1990s, one of the strongest economic growth cycles in US history. A PCE of 1.6 percent – where it is today – shouldn’t set off alarm bells.
All this aside, it is generally not a good idea to blithely ignore whatever message the bond market may be sending. No recession appears to be looming on the horizon, and the case for immediate Fed rate cuts is not as glaringly obvious to us as the conventional bond investor wisdom seems to have it. But the yield curve in its strange, scythe-like form doesn’t appear to be going anywhere either, and we must continue to give it due attention.
Just a couple years ago, the notion of “secular stagnation” was a favorite topic of conversation in the tea salons of the chattering classes. Secular stagnation is the idea that structural forces are at play pushing the growth rate of the global economy ever farther away from what we call “historical norms” (which really means “average rates of growth since the end of the Second World War”). Former Treasury Secretary Lawrence Summers was a leading proponent of the secular stagnation theory, pointing to widespread evidence of reduced levels of business investment and subdued consumer demand. Secular stagnation offers a different explanation of economic performance than the usual ups and downs of the business cycle. It suggests that the very idea of “historical norms” is meaningless: the world, and the world’s economy, has changed in profound ways since the 1950s and the 1960s, and there is no point in benchmarking current trends off those prevailing sixty and seventy years ago.
Hit the Mute Button
Secular stagnation lost quite a bit of mojo in the immediate aftermath of the 2016 election and the brief infatuation with the “reflation-infrastructure” phenomenon that was supposed to happen when the incoming administration turned on the full force of corporate tax cuts and deregulation. Although the tax windfall did arguably give a momentary sugar high to GDP growth rates, it didn’t have much of a sustained effect on business spending levels. And it had absolutely no effect on inflation. The chart below shows the long term inflation trend (core inflation, excluding food and energy) along with the corresponding ten year Treasury yield. The data go back to 1990.
There are a couple noteworthy things about this chart. The first is that inflation really has been a non-factor in the US economy since the mid-1990s. Core inflation has not risen above three percent since 1996. Through up cycles and down cycles, inflation has been – to use the word that is now embedding itself into the working vocabulary of the Federal Reserve – muted. And of course, in the recovery that began in 2009 core inflation has never even come close to the three percent level it last flirted with at the height of the manic real estate boom of 2006.
The second thing to observe in the above chart is the subduing of long term interest rates. We have talked about this in recent weeks, but here we focus on the 10-year yield as a barometer of inflationary expectations. One plausible reason for the persistence of the low benchmark yield – even after the Fed stopped buying intermediate term bonds as part of its QE programs – is that bond markets bought into the structural nature of muted inflation long before the Fed did. When the FOMC’s January 30 communiqué seemed to make official the Fed’s view of lower-for-longer inflation, one can picture the bond market replying thus: Thanks for telling me what I already know.
Alvin Hansen Gets His Day
And with that, a long-dead economist may finally have his life’s work recognized in formal monetary policy. Alvin Hansen was the originator of the term “secular stagnation,” way back in 1938. That was a grim year. Six years after the peak of the Great Depression, monetary authorities gingerly attempted to tighten policy and prevent the recovering economy from overheating. Things went south quickly, and policymakers realized that the economy was still too fragile to withstand traditional medicine.
Hansen’s secular stagnation theory seemed on the money at the time. Fortunately for the country, if not for Hansen’s own posterity, the theory quickly went out the window when the economy reflated onto a war footing as the Second World War broke out. Now that’s an infrastructure-reflation event! And dormant the theory lay until resurrected by Dr. Summers et al in the mid-2010s. We may still be one or two FOMC meetings away from calling it the dominant interpretation of today’s economy. But barring some genuinely massive exogenous shock to reflate the economy, the pattern of core inflation suggests that “lower for longer” is indeed what the world is going to have to get used to.
There is something almost symmetrical about it all. On December 19 last year the Federal Reserve delivered a hawkish monetary policy statement that sent the stock market into a tailspin. Two days later the US government shut down. Fast forward to January 25 of this year. The US government reopened amid generally upbeat sentiment in asset markets. Several days later, the Fed surprised traders with a decidedly dovish policy statement hinting at a pause, not only in further interest rate hikes but in winding down the central bank’s balance sheet of bonds purchased during the quantitative easing (QE) era of 2008-14. Stocks surged in the aftermath of that announcement and closed out a January for the record books. Hallelujah, exclaims Mr. Market. The Fed put is back and better than ever!
What Exactly Changed?
The January Federal Reserve Open Market Committee (FOMC) statement was not just a tweak or two away from the December communiqué – no, this was closer to a full-blown U-turn. As much as investors thrilled to the news that the Fed was solidly back in their corner to privatize gains and socialize losses, there was quite a bit of head-scratching over what exactly was so momentously different in the world over this 30 day interval. The FOMC press release seemed to say little about changes in economic growth prospects, with a strong labor market and moderate inflation paving the way for a sustained run of this growth cycle. True, it chose the world “solid” to characterize growth, which may be a slight demotion from “strong” as the adjective of choice in December. And yes, muted inflation affords some leeway to adjust policy if actual data were to come to light. But real (inflation-adjusted) rates are nowhere near recent historical norms, as illustrated in the chart below.
“Muted inflation” is the Fed’s term to describe the current level – but is it really “muted?” The chart above shows the Consumer Price Index (the blue dotted line) to be squarely within a normal range consistent with growth market cycles in the late 1990s and the mid-2000s. Yet in both of those cycles real rates were much higher, as is clear from the gap between nominal 2-year and 10-year yields (green and crimson respectively) and the CPI. Is the Fed worried that real rates at those levels today would be harmful? If so, there must be some element of fragility to the current economy that wasn’t there before.
Oh, Right. That.
Or, maybe that’s not it at all, as the FOMC press release sort of gives away in the next sentence. “In light of global economic and financial developments…” Aha, there it is, the language of the 2016 Yellen put reborn as the 2019 Powell put. What, pray tell, could those “financial developments” possibly be? A stock market pullback, blame for which was almost entirely laid at the feet of those two FOMC press releases last September and December? Once again, monetary policy appears to be based principally on ensuring that market forces not be given free enough latitude to inflict actual damage on investment returns.
And maybe that’s fine – perhaps the pace of growth will continue to be slow enough to allow the Fed to ease off the monetary brakes without any collateral damage. If that turns out not to be the case, though, then we foresee some communication challenges ahead. The data continue to suggest the growth cycle has a way to go before petering out. Today’s jobs report was once again robust, with year-on-year wage growth solidifying a trend in the area of 3.2 percent year-on-year. Unfortunately we won’t know about Q4 2018 GDP for some time, as the Bureau of Economic Analysis was impacted by the government shutdown and does not yet have a date for when its analysis will be ready for release.
March is probably safe – the likelihood of a rate hike then is now close to zero. But if Powell has to go back to the market sometime later in the year and ask investors to get their heads around another rate hike – a U-turn from the U-turn, in effect – that would likely be problematic. This Fed still has a learning curve to master when it comes to clarity of communication.
Financial markets move to the metronome of data, but not only data. Optics and perception also factor into the equation. Experience tells us that perception can quite easily become reality. Thousands of trader-bots are primed on any given day to lurch this way and that, often on the basis of no more than the parsed verbiage of a Fed speech or a “presidential” tweet. Sometimes the waves generated by those bots cross each other and cancel out. Other times they all find themselves going in the same direction and create a tsunami.
When “Buy the Dip” Met “Sell the Rally”
Many of the headline data points continue to suggest that there is little reason to worry. The latest batch of jobs data came out this morning and were not way out of line with expectations – net positive payroll gains and a steady, but not overheated, pace for wage growth. In public statements Fed chair Powell projects confidence about growth prospects heading into next year. But other indicators are flashing yellow, if not necessarily red. Oil prices suggest a tempered demand outlook. Fed funds futures contracts are sharply backing away from the presumption of three rate increases next year and perhaps even a shift back to rate cuts in 2020. The picture for global trade remains as opaque as it has been for much of the year, leading to reductions in 2019 global growth estimates by the IMF.
With that in mind, it seems increasingly plausible that the current volatility in risk asset markets is something different from the other occasional pullbacks of the past few years. This one is more grounded in the perception that an economic slowdown is ahead. Not “tomorrow” ahead or “next January” ahead, but quite plausibly sometime before the calendar closes on 2019. What we’re seeing in this pullback (for the time being, anyway) is a roughly balanced approach to buying the dips at support levels and selling into relief rallies at the resistance thresholds. Having made it through a negative October without the bottom falling out, the animal spirits to propel a sustained upside rally are thus far being kept in check. Perception is running ahead of actual data, as it frequently does.
Pick Your Flavor
None of this means that a slowdown (or worse) is absolutely, definitely in store in the coming months. But if it seems like an increasingly probable outcome, how does one prepare? There is never any shortage of blow-dried heads in the media to tell you that “when the economy does X the market does Y” with “Y” being whatever pet theory its proponent is hawking on the day. The problem is that there is no statistical validity to any kind of pattern one might discern between slow or negative growth in the economy and the direction of stock prices. There simply aren’t enough instances for an observation to be meaningful. The US economy has technically been in recession just five times since 1980 (two of which were arguably one event, the “double-dip” recession of 1980-81). There’s no statistical meaning to a sample size of n=5, just like flipping a coin five times does not give you the same insight that flipping a coin 10,000 times does.
The last three recessions occurred, respectively, in 1990, 2001 and 2008. The chart below shows the trend in real GDP growth and share price movements in the S&P 500 over this period.
Here is what jumps out from the above chart: the pullback in the stock market during the relatively mild recession of 2001 was much more severe than the one that accompanied the deeper recession of 1990. Consider: 2001 barely even made it into the history books as a technical recession (the story of how recessions become official makes for an interesting article in and of itself – stay tuned for our 2019 Annual Outlook this coming January!) Yet the bloodbath in stocks was a sustained bear market over nearly three years. By contrast, the market fell just short of, and never technically went into, a bear market during the 1990 recession. 2001 was closer in terms of damage done to the Big One, the Great Recession of 2008.
Here is where we come back to our favorite hobby horse: inferring useful meaning from past instances is misguided, because each instance has its own miserable set of unique variables, like every unhappy family in “Anna Karenina.” Before the 2001 recession happened, you will recall, the high-flying technology sector crashed in a stunning mess of shiny dot-com valuations. A financial crisis – a crisis born of nosebleed asset valuations – precipitated a minor contraction in the real economy. And of course in 2008 it was another financial crisis, this one deeper and holding practically the entire global credit market in its grasp, that begat the near-depression in the economy that followed.
We think of 2001 and 2008 as “recession-plus,” where the “plus” factor arguably contributes more to the severity of the pullback in risk assets than do the macroeconomic numbers relating to jobs, GDP, prices and sales. It was no fun for investors as those numbers turned south in 1990, but the pain was relatively shallow and short-lived. Not so for the multi-year tribulations of 2001 and 2008.
Now, there is no clear path from where we stand today to either a 1990-esque standalone recession, a more severe situation driven by exogenous factors, or just a simple slowdown in growth. Or even (though less likely) a second wind of the growth cycle driven by a yet-unseen burst of productivity. Nor has perception, while currently trending negative, yet become reality. We imagine those bot-generated waves will collide and cancel out a few more times before the trend becomes more sustainably directional. Meanwhile, planning for alternative scenarios is the priority task at hand.