Central bank tightening during a global growth slowdown as the curve flattens

Given what I know about the Fed’s reaction function, I believe pre-conditions favor Fed tightening irrespective of the slope of the yield curve.

This is the links post. But let me say something about monetary policy first. It’s not just the Federal Reserve that will be in tightening mode by year-end. Markets expect all the major central banks to join the US central bank in removing accommodation. And so 2018 will be the first year that we see a coordinated tightening campaign in more than a decade.

The inflation data are becoming less benign

Now, the Fed is the only central bank that has embarked on this path so far. And we got two pieces of data regarding the Fed’s reaction function yesterday. First was the consumer price index. This measure of consumer inflation is not the Fed’s preferred measure of inflation because it includes imported inflation. And the Fed is trying to discern how its policies are impacting the US domestically. So it tracks the Personal Consumption Indicator’s price index. And taking out food and energy, which are volatile, gives the Fed a trend in domestic price action to track. This number is below the Fed’s 2% target but trending up.

rising PCE core inflation invites Fed tightening

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But the inflation data yesterday were high, up 2.4% in a year and 2.9% on an annualized basis in the last quarter. A lot of this is housing, which makes up 40% of the core PCE Price Index. If you take housing away, you get 1.2% for core inflation. But still, this is where people spend their money. And the prices are rising.

The Fed is really close to four rate hikes in 2018

And so the second piece of data, the Fed minutes from March, was understandably hawkish. If you look at nowcasts for Q1 that ended in March, the numbers are weak. The Atlanta Fed’s GDPNow figure is at 2.0% annualized. But the minutes show that the Fed is looking through those data.

The staff projection for U.S. economic activity prepared for the March FOMC meeting was somewhat stronger, on balance, than the forecast at the time of the January meeting. The near-term forecast for real GDP growth was revised down a little; the incoming spending data were a bit softer than the staff had expected, and the staff judged that the softness was not associated with residual seasonality in the data. However, the slowing in the pace of spending in the first quarter was expected to be transitory, and the medium-term projection for GDP growth was revised up modestly, largely reflecting the expected boost to GDP from the federal budget agreement enacted in February.

Given the inflation data, and given unemployment near 4%, the Fed is very close to signalling four rate hikes in 2018.

The other central banks will start tightening too

You can see some of the stories in the links below. In Japan, workers are switching jobs and getting higher pay. In Denmark, where rates first went negative, Bloomberg has already written a post-mortem for negative rates. And the Germans are concerned about a potential property bubble in Berlin.

All of this suggests tightening is coming to the rest of the developed world.

Even so, we do have to worry about the recent global growth slowdown. For example, the Citi Economic Surprise Index (CESI) for the Eurozone, fell to -79.2 at the end of last week. That’s abysmal. It’s the lowest reading since at least April 2013.

Having said that, this could just be a blip, all weather-related and temporary slowing. Moreover, Citi itself has found that buying European equities when the CESI falls below -70 ended in a positive payout 14 times out of 15 in the past 15 years. The only exception was in 2008 when we had a financial crisis.

So I think the other central banks are going to look through weak Q1 data and begin tightening in 2018.

Watch the curve flattening

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I would have expected long-term interest rates in the US to have moved up by now. Instead the 10-year yield is below the level that triggered the ‘Great Correction’ in February.

What that means is that the Fed isn’t transmitting any of its tightening to the long end of the yield curve. For example, the gap between the 5-year and 30-year bond, is now at a post-crisis low. And we are now below 50 basis points between the 2-year and the 10-year yield.

What if this trend continues? What if the Fed continues to raise interest rates and transmits none of the increase to the long end of the curve? That would mean 50 to 75 basis points of tightening by year end. And it would likely mean inversion as a result. That would be a market signal for a recession.

As I have said before, my expectation is for 25 basis points between the 2-year and the 10-year by mid-year. That’s after the second rate hike. And, of course that would put the Fed one hike away from causing inversion. Recession could follow 12-18 months later.

We’ve been here before

Back in the last cycle before the financial crisis, as the Fed caused inversion, then-Fed Chair Ben Bernanke explained his view that:

to the extent that the flattening or inversion of the yield curve is the result of a smaller term premium, the implications for future economic activity are positive rather than negative

Further, he suggested:

the recent behavior of interest rates does not presage an economic slowdown but suggests instead that the level of real interest rates consistent with full employment in the long run–the natural interest rate, if you will–has declined.

And he backed a savings glut thesis for the changes in the yield curve:

Given the global nature of the decline in yields, an explanation less centered on the United States might be required. About a year ago, I offered the thesis that a “global saving glut”–an excess, at historically normal real interest rates, of desired global saving over desired global investment–was contributing to the decline in interest rates.

Expansions don’t die in their beds of old age. The Federal Reserve murders them

When the Fed first started raising interest rates late in 2015, it promised almost 300 basis points over three years. But when things went pear-shaped in 2016, the Fed stood pat for the balance of the year. It stood pat again in the second half of last year, as it started to roll off its balance sheet.

The question is what the Fed does now. We are later in the cycle. And we have a new Fed Chair. Asset prices are universally elevated. Unemployment is at 4%. And inflation measures are rising. Given what I know about the Fed’s reaction function, I believe this confluence of pre-conditions favors tightening irrespective of the slope of the yield curve.

That means the Fed could and probably will tighten right up until we have inversion. And then, we’ll just have to see if yield curve inversion is a reliable signal of recession or not. It has been in the past. If it is, that’s negative for stocks and it’s negative for other risk assets like high yield. But it would be bullish for Treasuries.

My baseline continues to be a Treasury curve with less than 25 basis points of steepness by mid-year. I expect expansion through the middle of 2019, with the first possibility of recession late in 2019 or in 2020.

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