The consensus today is that the global economy, led by developed countries, is heading into recession in the next few quarters. The debate ranges between hard or soft landing. Bloomberg’s recession probability forecast stands at 65% today. To add to this bleak outlook, we have Fannie Mae and Visa, companies with real economy visibility, forecasting an 85% chance of recession.
Some of this doom and gloom is based on the past relationship between surveys and hard data. Soft data points to the worst economic environment in half a century, only comparable to the Great Financial Crisis.
Financial markets are also forecasting an imminent recession when looking at the shape of the yield curve. The spread between 2-year and 10-year US Treasuries is the lowest since the high inflation period of the 1970s.
If we could point to only one data point to explain such dreary levels of survey responses and market pricing, it would be the speed and magnitude of the change in short-term nominal rates. The Federal Reserve hiked 425 basis points in nine months. This represents the fastest and largest rate-hiking cycle since the 1970s. The market and economists alike are saying that the current level of interest rates is incompatible with the economy’s structure. Markets believe that this level of rates will invariably cause the economy to contract, inflation to go back to 2% in the short- and long-term, and the Fed to start cutting rates in the second half of 2023.
The conclusion is valid if we accept the assumption that the trends of the 1985-2019 decades are still in effect, and that what we have seen over the past two years was just the effect of transitory impacts of Covid measures.
Having said that, markets are already broadly pricing these assumptions with a reasonably high confidence level. As investors, we must ask ourselves, ‘what if?’ What if there is a deeper reason for the past two years’ economic dynamics? What if we are not living through (only) transitory effects? Then, looking at nominal rates to predict a recession and a turning point for inflation would be misguided. And if so, the US treasury market would have to reprice materially in 2023, causing a structural shift in the global economy and financial markets.
Inflation in the period from 1985 to 2019 averaged 2.6%. This is when we saw the third wave of globalization, increased working-age population, plentiful fossil fuel energy, and the unquestioned Pax Americana. With inflation at such low levels, one would be excused if all its conclusions were based on nominal rates assumptions. But inflation is only low sometimes. From 1950 to 1985, as well as from 2019 to today, inflation averaged 4.5%. When inflation is higher, nominal measures become less important and it is essential to look at real interest rates. Here, we use the Fed Funds Rate deflated by YoY CPI.
Real interest rates tell a very different story. We have seen a sharp increase in real rates since the beginning of 2022, but that move started from a historically low level. Today, real rates are still extremely negative, even after 425 basis points of hikes from the Fed in 2022. The conclusions we draw from looking at this measure are very different from those based on the nominal rate. We see a monetary stance that is not restrictive and, therefore, supportive of growth. With that, we also see the probability of recession at very low levels in the next few quarters, and little reason for the Fed to start cutting rates in the second half of 2023 (let alone the 125 basis points of cuts the market is pricing in between 2H23 and 2H24 – see graph below). This measure helps explain why the labor market is so strong, something that keeps confounding central bankers and analysts alike. It also helps explain why surveys are so pessimistic. In periods of inflation, people tend to have a very pessimistic view of the economy, even when real growth is positive.
We must then ask ourselves. What if real rates are more important for the economy than nominal rates? What if the structural trends of less globalization, a decrease in the working-age population, scarce fossil fuel energy, and a multipolar world materially increase R*? What if the recent weakness in inflation numbers is just a transitory effect as part of a long-term structural inflationary period? What if growth surprises to the upside in 2023, even with the Fed keeping rates above 5%? What if?
he FOMC’s November meeting might have been one of the most important meetings in a long time.
At 2:00 PM EST, we saw a statement that was believed to be dovish by most and confirmed by market moves. It said that the FOMC expects that “ongoing increases in the target rate will be appropriate,” which even the most dovish observers would agree, but added that “in determining the pace of future increases in the target range, the Committee will take into account the cumulative tightening of monetary policy, the lags with which monetary policy affects economic activity and inflation, and economic and financial developments.”
Thirty minutes later at the press conference, Chair Powell struck a hawkish tone, focusing on the least dovish parts of the statement and provided more hawkish commentary, leading the markets to react accordingly.
He mentioned that rates would be higher for longer: “The incoming data since our last meeting suggest the terminal rate of Fed Funds will be higher than previously expected, and we will stay the course until the job is done.” There is no pause in sight: “It’s very premature to think about a pause in our interest rate hiking cycle.” And lastly, he would rather do too much than too little: “Prudent risk management suggests the risks of doing too little are much higher than doing too much. If we were to over-tighten, we could use our tools later on to support the economy. Instead, if we did too little, we would risk inflation getting entrenched and that’s a much greater risk for our mandate.”
In sum, we saw an intentional dovish shift in the language of the statement, followed by a much more hawkish message at the press conference. We have two main takeaways.
First, we might be seeing the first signs of a fracture happening within the FOMC. That is exactly what happened in the 1970s and it was the main reason that led Volcker to shift to a monetarist approach of targeting monetary aggregates, even though he was not a monetarist. Volcker was an incredible central banker not just because of his technical expertise, but also because he was a savvy politician. He understood that he could not bring all members of the FOMC along to raise rates as much as was necessary to curb inflation. In changing the way the Fed did monetary policy, he saw a way to unburden the FOMC members from this responsibility. He understood that it would otherwise be politically impossible to keep raising rates.
Secondly, Powell changed the shape of the distribution of potential rates outcomes with his comment on “prudent risk management.” If the FOMC follows Powell’s lead, we could see rates going higher for longer, but only at much smaller increments. That will be the compromise. With eight meetings in 2023, we are talking about a potential hawkish rate increase of 200-250bps for the full year (compared with 425-450 in 2022). On the other hand, if they find themselves to have overtightened, they will have roughly 500bps or more to cut, depending on when that happens. The risk of maintaining a paying rates position at the short end of the curve, which was probably one of the best risk-adjusted trades of the year, materially increased.
In A Tale of Two Cities, Dickens opens the book with a sentence that has become famous: “It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness, it was the epoch of belief, it was the epoch of incredulity (…)” This meeting might have marked the end of the golden age of monetary policy where consensus was the norm and developed markets’ central banks did not have to struggle with their dual mandate or politics.
Despite all the efforts of the most brilliant economists and analysts in the world to build models mimicking the methods of physics that follow their own self-contained logic, rules, and patterns to predict outcomes, when faced with failure, they dismiss it by claiming that “random shocks” had somehow disturbed equations and did not need to be explained since they are “nonrecurring aberrations.” War, pandemics, and politics are not abnormal historical events, only in economics.
However, many questions in economics can be approached more simply through history. In the most recent record, from 2010 to 2020, US CPI YoY averaged only 1.7%, below the Fed’s target (how much did that play a role in the recent late response from the Central Bank is anyone’s guess). However, in the history of the US, there are only a handful of times that the inflation picture could be described as stable.
Looking back at American history, we find six inflationary spiral events. The first occurred in the late 1700s just after the Revolutionary War; the second in 1813 after the War of 1812; the third in the 1860s during the Civil War; the fourth in the late 1910s after World War I; the fifth around and after World War II in the mid-1940s; and, the most current one in the 1970s associated with the Vietnam War. These periods were always followed by long periods of deflation. Evidence would point to politics, not economics, to explain inflationary spirals, and war looks like the common denominator. War in itself has many different impacts on inflation (as we discussed in this Macro Minute: The Reflexivity of Inflation and Conflict). Still, it is really the increase in money spent by the government, above what it collects in taxes, that makes inflation and negative real rates an attractive solution to the debt problem.
Looking back to the latest inflationary cycles of the 1970s, we find a few similarities and one significant difference. [1]
Similar to the present day, in 1975, the government balance sheet resembled conditions only tolerated during periods of war. And in the preceding years, just like recently, conservative governments that were supposed to be fiscally conservative were actually accelerating the deficit. In today’s world, for example, if interest rates rise above inflation, the Treasury’s interest expense goes up as debt rolls over, and the Fed reduces remittances to the Treasury. The Congressional Budget Office calculates that a 1% increase in real rates increases the annual deficit by $250 billion, about 1% of GDP, planting the seeds for an explosive debt dynamic.
In the 1970s, oil price inflation was a big problem, increasing to around 6 percent per month. More recently, on average, oil has been growing at 4.2 percent per month since January 2021. That includes the price corrections we saw in the last couple of months. The contribution to the CPI is still high at 47% YoY at current gasoline prices.
In the 1970s, real interest rates reached -4 percent. Today, we are living through the most extended period of negative real rates, currently sitting at -6 percent. That is before factoring in what can happen with nominal rates in a recessionary scare. We calculate real rates by subtracting the US Treasury 10-year yield by the current CPI YoY number. We believe this is a better indicator of real rates on Main Street than the real rates derived from the TIPS markets on Wall Street. This is the rate that alters the lives and actions of people who are not traders or advisors and who do not follow the FOMC decisions or read the Wall Street Journal. Different from the previous cycle, when the Fed was focused on impacting asset prices, to have an impact on goods and services prices, the central bank needs to focus on the decisions in the real economy and not in financial markets.
“At 15 percent inflation, an investor lending $1 million at 10 percent ‘loses’ $50,000 a year. You cannot count on the lender being a complete idiot, sooner or later, he will stop lending at low-interest rates and invest the money himself in commodities or real estate.” – Senator William Proxmire. October 1979
Another interesting observation from looking at real interest rates is that every recession is proceeded by positive real rates. More importantly, real rates tend to turn negative to help the economy once a downturn starts. This brings us to the recessionary debate. Like today, in 1979, most economists, including the Fed, were forecasting a recession. They had been wrong for many months, and in September, data showed the economy was not tipping over; it was accelerating again. This was true even with a deceleration in housing and autos and the fear of recession. “A Gallup survey found that 62 percent of the public expected a recession sometime in 1979.”
In an inflationary economy, people behave differently. Inflation doesn’t slow people down. With inflation at 16 percent, borrowing at lower rates seemed like a good deal. Bank credit was expanding at an annual rate of 20 percent. Most consumers did not care about what the higher interest rates were, as long as the monthly payments could fit their incomes. This is not a foreign concept for Latin Americans.
“Lenders were still surprised at how many families were willing to take on home mortgages at 13 percent or even higher. ‘ Perhaps it is not so hard to understand,’ Volcker said, ‘when you realize that the prices of houses have been going up at 15 percent or more.’” – 1979
Today, bank credit is growing at +12% for consumers and +8% for Commercial and Industrial clients. We’ve been following bank’s earnings calls very closely and we find that all the major banks see strong balance sheets, very low forward-looking default rates, and expect credit to grow in the mid-teens for the next few quarters. This past week, American Express reported that overall cardholder spending rose 30% from a year earlier.
Even when the Fed was finally able to create the presumed remedy, a prolonged recession that endured for 15 months with unemployment rising to 9.1 percent and industrial production shrinking to roughly 15 percent, as soon as the economy recovered, inflation came roaring back, rising even higher than before even with employment never getting close to its natural rate. With the supply of commodities constrained, even a short-term decrease in demand does not fix the inflation problem; it only postpones it to the following part of the cycle when policies revert to accommodative.
Lastly, the Fed genuinely did not know how much interest rates would have to rise to break inflation. If record levels of rates were not fixing the problem, how high would rates need to go to do it? Nor did it have the political capital to do what was necessary. Volcker acknowledges, ‘We could have just tightened, but I probably would have had trouble getting policy as much tighter as it needed to be. I could have lived with a more orthodox tightening, but I saw some value in just changing the parameters of the way we did things. (…) it would serve as a veil that cloaked the tough decisions.’”
“There is a wide concern about the Fed’s resolve in adhering to this policy in the face of an election year and the increasing likelihood of a recession. If strong words and actions are not followed by results, then holders of dollar-denominated financial assets in the US and abroad will conclude that the recent changes are no more significant than the statements and policy changes of prior years which did not reduce inflation. When rhetoric sufficed several years ago, tangible proof is now required of the Fed’s intentions.” – Federal Advisory Council 1979
The similarities are striking.
The main difference between the 1970s and today lies in the credibility that central banks around the world collected during a period of global deflationary forces that made them look like they could bend prices to their will and achieve their dual objective effortlessly, giving rise to the mantra “Don’t fight the Fed!” On July 14th, 2022, Governor Waller said, “The response of financial markets to the FOMC’s policy actions and communications indicate to me that the Committee retains the credibility and the public confidence that is needed to make monetary policy effective. (….) lenders and borrowers are still doing business at these rates, which indicates that they believe the FOMC’s policy intentions are credible, as broadly reflected in the interest rate paths in the Summary of Economic Projections (SEP).” Today, markets price the Fed’s projections to perfection.
What does history tell us about that? StoneX’sVincent Deluard shows us that using post-war data from the World Bank of more than 350 events when inflation spiked above 7%, only 1.4% of the time, inflation slows to less than 3% in each of the next five years. Markets are pricing 1 in 70 odds as if it were 100 percent certain.
“Acting hastily is essential to [a trader’s] profitability. If today’s quickest-to-the-keyboard move makes little sense according to some notion of ‘fundamentals,’ who cares? Overshooting is a feature, not a bug.” – Alan S. Blinder, July 2022.
“Traders must and do therefore respond literally instantly to all news to which they think other traders might respond. Whether the news is considered economically significant or even true is immaterial.” – Albert Wojnilower, Chief Economist at First Boston 1964-1986
This confidence also has an impact on the USD. With the expectation that inflation will converge to 2% in the next 18 months, interest rate differentials make the currency attractive. That, in turn, keeps inflation in the US in check. The DXY Dollar index is more than 17 percent up YoY, while the US CPI is 9.1 percent. Being conservative, we can assume a short-run currency passthrough in the US at about 25 percent.[2] This means that if the US Dollar was flat year-over-year, inflation should be a whopping +13%! This blind faith in central banks is what is keeping everything together. But history also tells us that after a long deflationary cycle and the build-up in credibility, what comes next is the drawing down of goodwill until there is nothing left.
“We’ve lost that euphoria that we had fifteen years ago, that we knew all the answers to managing the economy.” – Volcker 1989
[1] A good friend of the firm and fellow investor, knowing of our quest to understand history, pointed out to us that the team at MacroStrategy research was studying a book written in 1989 by William Greider called “The Secrets of the Temple” about the Fed’s fight against inflation under Volcker to help them with a similar pursuit. This book has been invaluable in our understanding of the period, and all quotes in this letter are from the book. https://www.amazon.com/Secrets-Temple-Federal-Reserve-Country/dp/0671675567/
[2] Campa, Jose Manuel, and Linda S. Goldberg. “Exchange rate pass-through into import prices.” Review of Economics and Statistics 87.4 (2005): 679-690. (https://www.nber.org/system/files/working_papers/w8934/w8934.pdf)
Exchange Rate Pass-Through and Monetary Policy, Governor Frederic S. Mishkin, at the Norges Bank Conference on Monetary Policy, Oslo, Norway. March 07, 2008 (https://www.federalreserve.gov/newsevents/speech/mishkin20080307a.htm)
Takhtamanova, Yelena F. “Understanding changes in exchange rate pass-through.” Journal of Macroeconomics 32.4 (2010): 1118-1130. (https://www.frbsf.org/economic-research/wp-content/uploads/sites/4/wp08-13bk.pdf)
On February 1st, at Credit Suisse’s 2022 Latin America Investment Conference, Enio Shinohara moderated a conversation with Rogerio Xavier from SPX and Luis Stuhlberger from Fundo Verde. In it, Luis made a very interesting remark on the US interest rates curve, which loosely translates from Portuguese to “so far in the United States, the increase in interest rates being priced by the market has simply anticipated a series of hikes, but has not changed the terminal interest rate. In other words, the first probability that appeared during the pandemic was for the first hike to happen in 2023 or 2024. In the past year, these expectations were repeatedly pulled forward. It started with one hike in 2022, and now we are talking about 5 to 6 hikes of 25 bps in 2022. But the terminal interest rate has not changed; the terminal interest rate is around 1.80%. In my opinion, and I agree with Rogerio, this will not be enough.” (I highly recommend watching the entire conversation, especially if you have any interest in Brazil: English Link, Portuguese Link).
Central banks around the world have one big problem today – inflation. This issue is even more apparent in developed markets that are mostly seen as behind the curve. From traditional macroeconomic models, we know that central banks can restrict the supply of money to ease pricing pressures; however, there are a few ways that this can be achieved. The two most common approaches are hiking short-term interest rates and pressuring long-term rates higher, both with meaningful, but different, redistribution effects. Historically, hiking short-term rates has been the method of choice at the Fed. That was also communicated at the last FOMC meeting and markets are pricing for it. Nevertheless, the situation is fluid and central banks, especially the Fed, may conclude that influencing long-term rates might be a better tool for the current environment and their updated mandate that now includes improving inequality.
The traditional way of relying on short-term interest rate hikes to lower inflation has the effect of controlling prices of goods by curbing demand through a flat or inverted interest rates curve, thereby causing a recession that generates the necessary slack to keep prices from rising. This method acts through raising unemployment and having little effect on asset prices. As Luis mentioned, hikes have only been anticipated with minimal impact on long-term rates, which in turn had little effect on mortgage rates and equities. In other words, this method exacerbates inequality. This is what the market is pricing today, with forwards implying an inverted curve in the US and Europe one year from now.
We believe that once this becomes apparent, the Fed will move into a more aggressive posture regarding balance-sheet reduction and steepening of the yield curve. Central banks have tools to control term premia, and by doing so can influence mortgage rates and asset prices. By increasing mortgage rates, they can keep home prices in check and consequently OER, with the added bonus of improving affordability. By decreasing asset prices, they might be able to bring early retirees back into the labor force (due to the decreasing values of their nest eggs), slowing, but not reversing wage growth, and consequently keeping services inflation tamed. Since we are not going through a balance-sheet crisis, central banks can engineer a soft landing without killing growth by pressuring long-term rates higher. This method would potentially have a positive impact on inequality. We hold a strong view that the probability of this scenario is higher than what the market is pricing.
In the early 1900s, President Theodore Roosevelt was known for the aphorism “Speak Softly and Carry a Big Stick.” The idea behind this adage is that it is the availability of raw power, not the use of it, that makes for effective diplomacy. In the case of Roosevelt, that policy worked very well. His two terms in office had been almost completely without conflict. “He has managed, without so much as firing one American pistol, to elevate his country to the giddy heights of world power.” – Literary Digest, December 22, 1906
Possibly empowered by the policy success almost 100 years earlier, in the early 2000s, the Fed decided to embark on a policy of forward guidance. Forward guidance is the act of communicating to the public the future course of monetary policy, namely, the path of interest rates. Said guidance, which along with the control of short-term interest rates and quantitative easing, had the aim of controlling the interest rate curve without so much as “firing one American pistol.” In hindsight, it worked. Forward guidance not only kept interest rates low through the expectations channel, but also helped dampen interest rate volatility (and along with that, equity and fx volatility).
However, the deflationary forces that provided the Fed with the availability of raw power began to dissipate around 2015. Raw power allows the Fed to introduce QE and rate hikes without needing to backtrack. This was ultimately eliminated once Covid incited a degree of globally coordinated fiscal and monetary policy never seen before. Since then, the Fed has flipped Roosevelt’s policy on its head. Today, the Fed is using FOMC press conferences and governors’ speeches to speak harshly on inflation. But when the time to act comes, we believe that the Fed does not have the same firepower as before. On one hand, it cannot materially tighten financial conditions without causing an enormous problem for the refinancing of historically high levels of debt (both corporate and government). On the other hand, with inflation rampant, it cannot continue to serve as a backstop to financial markets.
Going forward we believe that the Fed will speak harshly of inflation, but will consistently be behind the curve, possibly un-anchoring inflation expectations and the long end of the interest rates curve.
