The Fed rate hike and the potential for US recession
In the title, I tried to sum up what this post is about. But I have so many thoughts – post-rate hike – on what is happening, so I probably did a poor job.
Even so, let me say at the outset that have been pretty bullish on the US economy’s ability to power through. But I am uneasy about where we are in the economic and credit cycle and the accuracy of the Fed’s forward guidance. I think we are above stall speed now. But I also think global policy divergence, slowing earnings growth and poor capex numbers could combine to bring on recession in 2016.
Is it my base case though? No. I don’t have a base case right now. I think 2016 is very uncertain. For lack of a better phrase, let’s call it Knightian uncertainty that is keeping me from having a base case. And I think the Fed is underestimating the uncertainty simply because so many of the tail risks I outlined a year ago have materialized as this year comes to an end: oil, high yield, US capital expenditure, emerging market corporates and so on. What this tells me is not that I am a good soothsayer. No, it tells me that tail risk is elevated, more so now than ever. And that makes 2016 a wildcard for forecasters.
So what did the Fed do?
Here’s how I see the Fed rate hike. The hike was baked into the cake. The Fed – for a multiplicity of reasons – has wanted to raise rates for some time. But the data have never really come together enough for it to do so until now. I see the rate increase in and of itself as meaningless, especially given its size. But there are some other thing that are meaningful and they include:
- The pace of expected and likely hikes
- The shrinking of the Fed’s balance sheet
- The actual data dependency of the Fed’s future policy decisions
So let me take these one at a time. And then I will tell you a little bit about tail risk and recession, with a little help from some analysis by my friend Danielle DiMartino.
The pace of expected and likely hikes. The Fed’s dot plot says 100 basis points in 2016 and 100 basis points in 2017. Do you think that’s likely? I don’t. The market doesn’t either. The market is telling us it sees 50 basis points in 2016. And that’s a signal it believes the economy is weaker than the Fed’s forecasts.
Given the weak numbers on industrial production and manufacturing, given the three straight quarters of earnings weakness, the continued carnage in energy and in high yield, and the capex shortfalls, I see a 2%ish rolling real GDP growth number as the high. And if the Fed is hiking 100 basis points in that case, you’ve got a problem. That’s the Fed murdering this recovery in its sleep, not the recovery dying of old age.
In short, you have a dichotomy between the Fed’s optimistic view of future growth and of the likely path of rates and the market view on these. To the degree the Fed is 100% data dependent, this dichotomy is not meaningful. But to the degree other factors come to bear on the Fed’s reaction function, you have the makings of stall speed or even recession.
The shrinking of the Fed’s balance sheet. Now I talked to Danielle DiMartino Booth about this. Her take is that 25 beeps is chicken feed when you compare it to the $3.6 trillion dollars in balance sheet expansion the Fed has undertaken. To the degree the Fed does not reinvest maturing bond funds in more product, you have a shrinking balance sheet and de facto tightening.
And let’s also remember that – in a world of tight fiscal – to the degree the Fed DOES reinvest, you have a central bank soaking up a ton of safe assets, pushing investors out the risk spectrum and creating both more malinvestment and greater systemic and liquidity risk. And that’s because private debt instruments are not safe assets. They can’t substitute for government liabilities no matter how they are packaged and sold. Remember that when the next liquidity crisis hits.
Back to Danielle’s point though, she wrote the following this morning that you should read:
What if it really is all about reinvestment and not one teensy quarter-point rate hike? Over the next three years, some $1.1 trillion in Treasurys could roll off the Fed’s balance sheet if reinvestments were to cease. Tack on the potential for mortgage backed securities (MBS) to prepay and/or mature and you’re contemplating a figure that approaches $2 trillion.
Make no mistake, shrinkage of the Fed’s balance sheet to half its current size is much more feared by market participants than a slight tick-up in interest rates.
Take a look at some of her commentary in the video below from our conversation on Boom Bust. Skip forward to 3:32 in the video.
Yellen says the normalization process will be well advanced before balance sheet shrinkage begins. Dudley says they’re talking 1 or 1 1/2% on the Fed Funds by that time. So we’re talking 12 to 18 months here given the dot plot. That’s when the balance sheet shrinks. To my mind, this is going to be the sticky wicket in getting off the zero lower bound – that is if we get that far.
The actual data dependency of the Fed’s future policy decisions is the question then. Listen to what Yellen said at the post-hike presser. Yes, she said the Fed would be careful. She said the Fed would monitor developments in high yield, in currency markets, and inflation. She gave lip service to all these things. But she never made any explicit statements about when and how these things would stop the Fed hike train cold in its tracks. Go back and watch the clips and you’ll see what I mean.
On the other hand, Yellen made a lot of bold statements on the other side of the policy issues. Yellen told Jon Hilsenrath of the Wall Street Journal, “we recognize inflation is well below our 2% goal” but that “I’m not going to give you a simple formula” on the inflation front. Translation: we can hike without inflation rising.
Yellen said about plunging energy prices, “I have been surprised by the further downward move in oil prices” but that all we need to see is oil prices stabilize to continue to feel comfortable hiking rates.
Yellen said “I do not think [economic expansions] die of old age. I do not think [their] days are numbered,” but that “when you say central banks often kill [recoveries]… central banks have gone too late to tighten policy.” Translation: tighten sooner to avoid having to tighten excessively later, and risk choking off an expansion.
Yellen also said that the Third Avenue Focus Credit fund was an atypical high yield fund focused on much lower quality credits than average. So it was not a canary in the calming and that it had no systemic relevance.
None of these statements is dovish. In fact, I would say none of these statements are suggestive of data dependency in term of policy. Instead they are highly suggestive of a Fed that WANTS to normalize policy and will do so irrespective of the data, unless the data get really bad. This is why industrial production and manufacturing weakness is irrelevant. This is why the lower corporate earnings does not put the Fed off hikes. And this is why the slowing number of average non-farm payrolls additions do not have the Fed worried.
Maybe the Fed realizes low rates have spawned a huge risk-on bet and wants to prevent it from getting any bigger. I don’t know. What I do know is that the Fed is not 100% data dependent. It has a policy bias – and that bias now is tightening. Only poor data will put the Fed off that bias.
Bottom line: the rate hikes are coming unless the economy falls out of bed. And the markets are not expecting this.
The real economy is weaker than the Fed thinks
Now, the Fed’s tightening bias works just fine in a non-stall speed economy — like the one we have — if the economy is stable to improving. But the data these days suggest otherwise. Here are some data points Danielle sent me on this front. She emailed me the following list:
- Low oil prices are proving to be anything but transitory as they plumb fresh lows – both as they pertain to inflation and to economic damage via the channel of the loss of high paying jobs (this is, by the way a global phenomenon and global drag that renders the U.S. economy that much more vulnerable)
- It is not just the mining sector that is showing signs of weakness. Manufacturing output has risen by 0.9 percent over the past year through November, an appreciably slower pace than 2014’s 3.3% growth rate. This is saying something as motor vehicle sales have been roaring ahead providing a key support for the economy thanks to subprime auto lending pushing lending standards down to the lowest on record.
- Yes, the economy is creating jobs – but the ratcheting downwards in average monthly payroll gains to 211,000 from 260,000 in 2015 cannot be dismissed, especially in light of employment being the most lagging of indicators.
- Housing has been propped up in a large way by the high end. Financial markets jitters and a strong dollar, though, have cooled high-end housing markedly over the past several months. The risk, with the first subprime RMBS priced just recently, is that first-time homebuyers are finally getting some relief from tough credit standards at just the wrong time. It would be rough for them to be buying in to overpriced markets whose house prices have been propped up by investors and high-end sales.
- The recent rout in the junk bond market could lay bare some other areas of lending that have gone wild in recent years. Any sort of a contagion effect would be made readily apparent in the event the economy slipped further
- Finally – the Fed has not played the business cycle (which I’ve repeated with great frequency) – at 78 months, it’s about time we hit recession, unless we’re headed for one of the longest expansions in history, this on the heels of one of the greatest balance sheet recessions of all time?
I agree with that list and I have a few more thoughts on her next to last point that I want to add. Let me repeat what I wrote Tuesday regarding contagion:
“The sectors to concentrate on here are the ones where we have yet to see any big problems. We should be thinking about natural gas as another sector here because today the natural gas futures market hit the lowest levels since 2002, due to unseasonably warm US weather. I would say sectors to watch also include US municipals, Canada and Australia. In the event we do have a sudden stop of credit, expect the knock-on effect for energy and commodity markets to bring Canada and Australia into the picture. And a recession in the US would bring US municipals in as well. In a recession scenario, we would also have to think about auto and student loan ABS as areas that would add distress to the financial system.”
So let me give you a scenario here. In an environment in which earnings are shrinking and oil prices are declining, capital investment gets cut. And then the question becomes how much residential investment and consumer consumption growth can overcome this factor.
In a Goldilocks scenario low rate lock-in behavior causes borrowers to pull forward their borrowing decision, pushing up credit growth while the energy sector works through its malaise and the baton is passed to wage growth to do the heavy lifting of maintaining consumer spending . That’s what the Fed hopes will happen.
In a worst case scenario, the real economy effects of the oil sector and the earnings slowdown hit the frothy commercial real estate and REIT sector, which in turn begin the widening of the contagion begun by energy high yield. Combine this with the sudden stop to lower quality energy credits I believe is inevitable and you likely have stall speed – or even recession. And that’s where subprime auto ABS, student loan securitization and US munis come into the picture for the US domestic economy. Those markets get hit in recession.
Moreover, if the Fed hikes four times in 2016 and four more in 2017 – as the Fed’s dot plot says – where is the US Dollar during that chain of events? And what does China do? Some people are saying “given the dollar’s strength against emerging market currencies, a true free float could spark a devaluation of more than 30 percent.” I think 30% is a big number. But this is the type of uncertainty policy divergence means, folks. If you’re looking for a black swan, there you go. I would say the Fed’s baseline outcome of 200 basis points through the end of 2017 causes a conscious uncoupling for the Renminbi, and gets felt as global deflationary pressure to add to any US domestic pressure.
200 basis points is also very bad news for commodities and energy. Look at natural gas, now on my implosion markets. It was trading at $1.79 per MMBtu at the close of trade yesterday well into the 2002 lows. 200 basis points means a strong dollar and that means even weaker commodity and energy prices. And this is particularly negative for natural gas in the US, since the ability to export it is limited. Almost certainly then, the Fed’s base case is a catastrophe for the commodities sector and energy capex. There’s no way we get that base case without a significant shortfall in demand on that side of the equation.
I would like to think the 2%ish growth train could continue, even as the Fed finally begins rate hikes. If I had a 2016 baseline, that would be it. However, the imbalances that have built up domestically and globally throw a lot of uncertainty onto the economic forecast for 2016. I thought tail risk in 2015 was going to be elevated – and it has been. But I believe tail risk in 2016 is worse and most of those risks are to the downside.