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Macro Minute: Financial Stability Real Interest Rate

Since the Great Financial Crisis, monetary policy has emerged as a critical factor for investors. Gaining insight into central banks’ perspectives on the natural level of interest rates and their limitations  crucial for achieving significant investment returns.

Why it matters: The Federal Reserve faces a challenge in balancing the long-term monetary policy rate needed to meet inflation targets (r*) with the level of the real interest rate that can potentially lead to financial instability (r**). Past experiences have demonstrated that, when confronted with this decision, the Federal Reserve has typically prioritized financial stability.

Financial Stability Real Interest Rate

The concept of the natural real interest rate, r*, has long been associated with macroeconomic stability. However, recent research[1] introduces a complementary notion called the “financial stability real interest rate,” r**. By examining the relationship between interest rates, financial vulnerability, and the real economy, we can uncover valuable insights into the dynamics of the financial system.

Defining the Financial Stability Real Interest Rate

The financial stability real interest rate, r**, is the level of the real interest rate that generates financial instability. It is quantified based on an environment where financial intermediaries face occasional binding credit constraints, leading to asset fire-sale dynamics. This two-state framework differentiates between financially tranquil periods and financial crises. r** serves as a quantitative summary statistic for financial stability, akin to r*’s role in measuring macroeconomic stability.

Implications of Interest Rate Movements

Consider a scenario with prolonged lower real rates. Initially, financial intermediaries benefit as their asset portfolios appreciate, boosting net worth and reducing leverage. Consequently, they are more willing to lend. However, the pursuit of higher yields leads to increased exposure to risky assets over time. This growing vulnerability makes intermediaries susceptible to the risk of insolvency in the face of future adverse economic shocks.

Interest rate changes have distinct impacts on financial stability in the short and medium run. In the short run, valuation effects similar to those observed during the 2023 banking turmoil dominate. r** measures the extent to which a surprise increase in rates can push the economy towards a crisis during tranquil periods. Conversely, during financial crises, r** indicates the necessary rate cut to alleviate the balance sheet constraints on financial intermediaries.

Interpreting Banking Turmoil

The collapse of Silicon Valley Bank provides a narrative to interpret financial vulnerabilities within the proposed framework. Two key elements, leverage ratio and the ratio of safe assets to total assets, play a crucial role in determining the banking sector’s vulnerability. The combination of a rapid increase in the Fed funds rate and quantitative tightening resulted in reduced reserves (considered safe assets) and potential unrealized losses in long-term Treasuries. These factors heightened effective leverage and raised financial vulnerabilities. Sales of such securities to meet deposit withdrawals exacerbated these vulnerabilities.

Evolution of the Financial Stability Real Interest Rate (r**)

Tracking the evolution of r** from the 1970s to 2022, notable patterns emerge. During the first part of the Great Moderation period, r** was consistently higher than r, with only short-lived stress episodes causing deviations. In the 2000s and after the Great Recession, the gap between r** and r narrowed. However, in the mid to late 2010s, r** once again surpassed r, except during brief periods of stress. The COVID-19 pandemic brought about significant financial stress in March 2020.

The concept of the financial stability real interest rate, r**, offers insights into the relationship between interest rates and financial stability. By considering the dynamics of the financial system, the effects of interest rate changes on vulnerability, and the implications for the real economy, policymakers gain valuable tools for decision-making.

The authors, affiliated with the Federal Reserve Bank of New York’s Research and Statistics Group, caution that r** should be viewed as a current indicator of financial stress rather than a predictor of future vulnerabilities. However, upon closer examination, we find that this model presents an inherent dilemma between the long-term monetary policy rate required to achieve inflation targets (r*) and the level of the real interest rate that gives rise to financial instability (r**). History has shown that, when faced with this choice, the Federal Reserve tends to prioritize financial stability.

[1] Measuring the Financial Stability Real Interest Rate, r** – Liberty Street Economics (newyorkfed.org)

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Macro Minute: SVB takeover and Credit Suisse Acquisition- Signs of a looming Minsky Moment?

In recent weeks, concerns over bank solvency have resurfaced in the markets, with Silicon Valley Bank (SVB) being taken over by regulators and UBS acquiring Credit Suisse for $3.2 billion. The takeover of SVB marks the second-largest bank failure in U.S. history and the most significant since the 2008 financial crisis.

Why it matters: While some attribute the recent events to executive mismanagement, we contend that they are symptomatic of a broader systemic issue. Rather than isolated incidents, they may represent the opening act of a potential future collateral crisis. What’s particularly worrisome is that if the collateral in question is so-called “risk-free” government bonds, we could be entering uncharted territory, leaving us with little recourse to address the issue. The short-term impact of recent events could be a significant curbing of credit to the economy, while the long-term impacts could pose an even more significant challenge to the financial system than the Great Financial Crisis.

The short-term effects of the most recent banking stress will be to reduce credit in the economy.

  • Regional banks are likely to curb credit for three primary reasons:
    • First, increasing regulation and the risk of executive prosecutions for mismanagement will create a risk-averse environment, leading these banks to reduce lending.
    • Second, the newly formed mechanism that gives these banks direct access to the Fed will increase the relative attractiveness of securities that can be posted as collateral, thereby decreasing the attractiveness of loans.
    • Lastly, the drop in deposits in these banks will create a hole that must be filled through wholesale funding provided by money market funds. While access to funding won’t be a problem, the rates charged for this funding will be higher than those on deposits, increasing costs for these banks, thereby pressuring their margins, reducing their profits, and potentially disincentivizing them from making new loans.
  • The recent events will also impact large banks, causing them to take a risk-averse stance for two main reasons.
    • First, the FDIC is not backed by taxpayer money but by the banks, particularly the well-run large banks. Apart from the direct cost of insuring all deposits of SVB, the possibility of new regulations requiring the FDIC to insure a larger portion of deposits will drive the profitability of these banks lower, reducing their willingness to lend.
    • Second, with regional banks now having direct access to the Fed, there is a new price-insensitive buyer of Treasuries that could pressure long-term rates lower while the Fed keeps the short-end of the curve higher through its hiking cycle, making curves flatter and reducing bank profits and their willingness to lend. These factors could lead to tightening credit and financial conditions, which could have significant implications for economic growth and stability.

The long-term effects of the debasement of US Treasuries could be catastrophic to the global financial system.

  • While it’s true that critics have pointed to mismanagement as a contributing factor in the sudden collapse of SVB, this only scratches the surface of a more significant issue at play. Banks were led to invest heavily in risk-free (US Treasuries) and quasi-risk-free (government-guaranteed) assets due to financial repression and regulation. “Hold to maturity” accounts further fuelled this trend by increasing the allure of such assets, leading to a dangerous level of complacency among banks. Therefore, while SVB may have been the first to fall, the underlying problem is much more pervasive and requires a more comprehensive solution. The possibility cannot be dismissed that we may be witnessing the initial signs of what could be the most significant Minsky Moment in history.

Named after economist Hyman Minsky, a “Minsky Moment” refers to a sudden collapse of asset prices following a long period of growth. Minsky believed that during periods of economic stability and growth, investors and lenders become increasingly complacent and take on more and more risk. This leads to a build-up of financial fragility, with borrowers becoming increasingly over-leveraged and lenders becoming more lax in their lending standards.

Eventually, the economy reaches a tipping point where borrowers can no longer meet their obligations, and the value of assets used as collateral declines rapidly. This triggers a panic among lenders and investors, who try to liquidate their assets, causing a further reduction in asset prices and triggering a financial crisis.

Minsky moments have been observed in many historical financial crises, such as the 2008 global financial crisis, the dot-com bubble burst in the early 2000s, and the savings and loan crisis in the 1980s.

  • It’s worth noting that the estimated losses on securities only represent a fraction of the total unrealized losses that banks have experienced due to the rise in interest rates. Loans, much like securities, also experience a decrease in value when interest rates increase. With a total of $17.5 trillion in loans and securities as of December 2022 and an average duration of 3.9 years, the total unrealized losses on bank credit amounted to approximately $1.7 trillion (calculated as $17.5 trillion x 3.9 x 2.5%). This figure is only slightly less than the total bank equity capital of $2.1 trillion in 2022, indicating that the losses resulting from the interest rate increase are on par with the entire equity of the banking system.[1]
  • While it’s crucial to consider losses incurred on assets, even if they are unrealized, the most significant issue is the impact those losses have on a bank’s ability to refinance its outstanding debt. Financial institutions rely heavily on short-term, wholesale dollar funding through collateral considered “safe.” However, a lack of such “safe” collateral can lead to a catastrophic failure of the financial system. Therefore, while the losses on assets are important, the loss of confidence in the ability to refinance their outstanding debt poses the most significant risk to the banking system.

A prime example of the risks associated with a lack of “safe” collateral can be seen in the lead-up to the 2008 Global Financial Crisis. JP Morgan provided cash to Lehman Brothers to conduct its daily business. However, as Lehman’s collapse loomed, JP Morgan began to question the value of the collateral that Lehman had pledged, suspecting that it was worth less than initially claimed. As a result, JP Morgan required Lehman to pledge more collateral as a condition for continuing its operations. This scramble for the most “pristine” collateral highlights the dangers of a shortage of “safe” collateral, which can ultimately lead to a decrease in USD funding worldwide as chains of wholesale dollar transactions begin to unravel.[2]

  • What could cause the debt of a sovereign country with a free-floating exchange rate and holds reserve currency status to become risky? Inflation. The Fiscal Theory of the Price Level suggests that higher inflation may be forthcoming, which could lead to the “risk-free” status of government bonds being called into question. If this were to occur, it could potentially leave us in uncharted territory with few tools at our disposal to address the issue. Therefore, inflation poses a significant risk to the perceived safety of government bonds and could have far-reaching consequences for the broader financial system.

The majority of U.S. government debt is issued with a nominal face value in U.S. dollars, meaning its real value or purchasing power is determined by dividing the value of outstanding nominal debt by the price level. The intertemporal government budget constraint stipulates that the real value of debt is linked to the real value of future surpluses. When considering the intertemporal government budget constraint as an equality, changes on the right-hand side (such as increases or decreases in future fiscal variables) correspond to changes on the left-hand side (i.e., real debt). Since the nominal value of outstanding debt is predetermined, the price level is the variable that adjusts to reflect changes in fiscal variables on the right-hand side of the constraint.[3]

Our own analysis also shows[4] that we do not anticipate the favorable inflation outcomes of the past three decades to continue over the next few decades. Apart from a stronger fiscal position, the favorable inflation environment of the past three decades was partly due to the increased global productive capacity resulting from the dissolution of the Soviet Union and the inclusion of China and India in the global trading market. Additionally, financial markets had become more interconnected, resulting in the greater deployment of the world’s savings toward cross-border investment financing. These factors contributed to lower inflation expectations and reduced risk premiums.

[1] Source: Itamar Drechsler, Alexi Savov, and Philipp Schnabl, “Why do banks invest in MBS?,” New York University Stern School of Business, March 13, 2023.

[2] Modern Macro by Zachary Cameron.

[3] Lubik, Thomas A. (September 2022) “Analyzing Fiscal Policy Matters More Than Ever: The Fiscal Theory of the Price Level and Inflation” Federal Reserve Bank of Richmond Economic Brief, No. 22-39.

[4] Macro Minute: What If (Dec 2022), Macro Minute: A Tale of Two FOMCs (Nov 2022), Catalysts Into Year-End (Oct 2022), Macro Minute: We Learn From History that We Do Not Learn From History (July 2022), Norbury Partners 2022 Annual Report (June 2022), Macro Minute: Flat as a Pancake (Mar 2022), Macro Minute: The Reflexivity of Inflation & Conflict (Mar 2022), Macro Minute: Speak Harshly and Carry a Small Stick (Feb 2022), Special Report: A Changing Paradigm (Aug 2021) – for any of these reports, please contact [email protected] or visit our website.

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Macro Minute: What If?

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?

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Macro Minute: Reopening & Re-Easing of Financial Conditions

China Reopens

Over the course of November, rumors gave way to real policy and rhetoric changes from the Chinese government pointing to a gradual reopening of China’s economy and the backing off of Zero-Covid policies. We saw a modest rally in commodities and beat-down Chinese tech names moved higher in the equity market, but an examination of asset class performance as lockdowns reversed in the West can give us some clues to the performance of asset classes over the next several months. 

At the onset of Covid, swift and extreme lockdowns drove commodity and equity prices lower, as well as the yields on long-dated US Treasury bonds (using TLT as a proxy). As the first wave of lockdowns eased, we can see that the first asset class to move back towards pre-covid levels was equities (using MSCI ACWI as a proxy), where the rally didn’t cool off until central banks began hiking rates and yields on US long bonds began to recover in 2022. Commodity markets moved next, with increasing economic activity from less severe lockdowns leading to increased consumption of commodities, be it agricultural or energy. The correlation between commodity prices and Western lockdowns is fairly strong; commodity prices (using Bloomberg Commodity Index as a proxy) traded range-bound when the lockdown index flat-lined in 2021, and then began to rally again as lockdowns effectively reversed as we entered 2022 before trading effectively range-bound again.

With the reopening of China, we’d expect a similar phenomenon. Equities price expectations of future cash flows and are likely to be the fastest asset class to recover with new policies as investors discount greater cash flow in the coming years from an open China. Commodities are a real asset, and while speculative capital is active in the space, demand will have to pick up with increased economic activity for fundamentals to move prices higher. Using the same Lockdown Index methodology used above for North America and Western Europe, even with recent relief, China is somewhere between 35 and 50, equal to that of Western economies in the summer of 2020 or early-2021.

China is one of the largest consumers of commodities in the world. Looking through the weakness in backward-looking Chinese data will be important when determining where commodities prices may be heading.

FOMC December 13-14th, 2022

At the same time, we’re looking ahead to next week’s FOMC meeting. In June, after the Fed introduced jumbo-sized 75 basis point hikes, commodity prices and inflation breakevens fell, bonds rallied, and the market began to price a Fed pivot resulting in a bout of easing financial conditions ahead of the July meeting. The Fed considers tighter financial conditions essential to achieving goals around price stability, and after the market perceived the July press conference as dovish, Chair Powell used his speech at Jackson Hole to drive home the Fed’s goals for tighter financial conditions.

Since the November meeting when the Fed alluded to slowing the pace of rate hikes, financial conditions (as measured by the GS US Financial Conditions Index) have once again loosened to where they were at the June FOMC meeting and 10-year bonds have also aggressively rallied, with yields similarly around where they were at the June meeting. Given the Fed’s focus on tighter financial conditions, and its response the last time conditions loosened so quickly, we expect a combination of more hawkish rhetoric and/or a more aggressive dot plot to drive financial conditions tighter and yields higher coming out of next week’s meeting.

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Macro Minute: Is Deep-Sea Mining the Answer?

For many decades now, world leaders have slowly come to terms with the realities of climate change. More recently, we have seen the public and private sectors starting to translate promises into actions through various investments. As we move from theory to practice, agents are beginning to run against obstacles that were not clear before.

It has become increasingly clear that the world lacks the investment in natural resources necessary to make the green energy transition a reality. Setting aside the requirements for building solar and wind power on a global scale, the Geological Survey of Finland (GTK) recently released a study examining the volume of metals needed to build the first generation of electric vehicles (e.g., replacing every vehicle in the global fleet today with one EV) and the power stations (e.g., batteries) necessary to store intermittent electricity generated from renewable sources. They estimate that one generation of electric vehicles (1.39 billion) will require over 280 million tons of minerals and another 2.5 billion tons of metals for power storage projects to support such an increase in electricity consumption. In sum, current estimates for global reserves of nickel, cobalt, lithium and graphite are not sufficient to support such a massive undertaking.

To aggravate the problem, investments to transform reserves into actual ore are faltering. Existing mines for copper in places like Chile have under-produced expectations meaningfully this year. Reports from the recent 121 Mining Conference in Sydney highlighted the issues of getting new projects approved and on track for production, characterizing the challenges as “multiplying” for myriad reasons, including higher interest rates, low and volatile mineral prices, and ESG concerns.

On the geopolitical front, the ongoing realignment of world power will also have a material impact on access to materials and their ESG qualities. The world’s largest nickel producer is Indonesia, where mines are developed in the most biodiverse biome on the planet—rainforests; its biggest and cheapest nickel operation is Nornickel, located in Russia. The world’s largest cobalt producer by far is the Democratic Republic of the Congo (DRC), where not only does the climate range from tropical rainforest to savannahs, but also the exploitation of child labor is a major social concern. While China is responsible for 64% of graphite mining, it also has a controlling interest in much of the DRC’s cobalt production, and maintains an overwhelming majority of the refining capacity for lithium, nickel sulfate, manganese and graphite.

The unprecedented demand for green-transition minerals meets a supply picture that is very constrained and will generate prohibitive costs to the energy transition. That happens while billions of people lack cost-effective access to the energy they need to prosper.

Deep-sea mining offers a very interesting alternative to this problem. The USGS estimates that the Clarion-Clipperton Zone, “the largest in area and tonnage of the known global nodule fields,” contains 21.1 billion tons of dry nodules. Based on that estimate, tonnages of many critical metals in the CCZ nodules are greater than those found in global terrestrial reserves. Given the high ore grades found in nodules, and the simplicity of recovery, many companies in the space estimate that deep-sea nodule recovery will be one of the lowest cost producers of critical minerals in the world. The same USGS publication mentioned above notes, “if deep-ocean mining follows the evolution of offshore production of petroleum, we can expect that about 35–45 percent of the demand for critical metals will come from deep-ocean mines by 2065.”

Like any extractive activity, this kind of endeavor also carries costs along with its benefits. However, their costs are different from what one would think at first. The vanguard of deep-sea mining does not involve drilling and mining pits. Instead, it is focused on the harvesting of nodules. Nodules are fist-sized lumps of matter that collect on the ocean floor over thousands of years when currents deposit mineral sediments. Different parts of the ocean contain nodules rich in different elements. Those found in the Pacific Ocean have been shown to contain incredibly rich deposits of copper, nickel, cobalt, and manganese with ore grades superior to many, if not all, of today’s land-based reserves. Nodule collection occurs between 4,000-6,500 meters in the aphotic zone where sunlight does not penetrate and biodiversity is faint. Its process is minimally invasive and entails the scraping of about 6 inches of the ocean floor to separate nodules from sediment, depositing most of what is not used back to its original place. MIT researchers recently published results of a study demonstrating that 92% to 98% of the sediment either settled back down or remained within 2 meters of the seafloor as a low-lying cloud. The plume generated in the wake of the collector vehicle stayed roughly in the same area rather than drifting and disrupting life above.

The benefits are potentially many. From an environmental point of view, this process has enormous advantages when it comes to the impact on deforestation, destruction of carbon sinks, and water usage. From a social aspect, deep-sea mining also appears to be superior to other extractive activities on land, with limited exposure to the negative social dynamics of social displacement, corruption and child labor. If proven to be cost-efficient, it would also promote clean and cheap energy creating prosperity for billions of people. Should the environmental studies of nodule collection continue to be positive, nodules present a promising alternative to solve our natural resource problem in the face of a green transition. As the West looks to become both greener and less dependent on “unfriendly” sources of labor and natural resources, it must take a pragmatic approach toward deep-sea mining, recognizing that there is no such thing as a perfect solution, but this could be the next best thing for achieving the future we want.

This article appeared on Forbes.

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Macro Minute: A Tale of Two FOMCs

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.

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Catalysts into Year-End

We’ve spent most of the summer discussing macroeconomic trends and data (from inflation to employment) that could change the course of policy and markets, so today we want to focus on a handful of catalysts between now and the end of the year that could have meaningful consequences for asset prices.

China 20th Party Congress

The 20th Party Congress begins on October 16, amid economic turmoil in the country largely driven by the property crisis and Zero-Covid policies.

What’s at stake?

It is widely believed that President Xi Jiping is aiming for a third consecutive (and likely life-long) term as President, bucking the trend of two-term limits established by law in the 1990s then reversed by constitutional amendment in 2018. On the real estate front, China has already begun to implement measures to provide relief to the troubled market and its developers by implementing a $29 billion loan program to help developers finish halted projects, relaxing home purchase restrictions, and lowering the mortgage rate for first-time homeowners in cities where selling prices continued to fall over the summer. With power consolidated post-Congress and a focus on Common Prosperity, we believe there is a chance of greater central government intervention in the market to assuage resident’s concerns about the sector and restart growth given the Chinese real estate market accounts for roughly 25% of the economy.

On September 30, Xi and other members of leadership attended National Day celebrations without wearing masks at one of their last public appearances before the Congress. This, along with Chinese MRNA vaccines being rolled out in Indonesia, could point to shift in Zero-Covid policies on the other side of the meeting. The last patient entered the 28-day EUA test for efficacy against current strains on August 29, and results are expected this month. With EUA approval of one or a handful of the 14 drugs that went to trial in November, we could see a full reopening of the country by April next year given the available vaccine manufacturing capacity.

What’s it means for markets?

China is one of the largest consumers of commodities in the world. A reprieve on the property front would put a floor under building materials like steel, copper, and aluminum. A reversal of Zero-Covid rules and the reopening of the country would boost goods consumption, improve mobility, thereby increasing energy consumption, and increase non-residential fixed asset investment in sectors like renewable infrastructure. Altogether, these changes would represent a material change to the demand-side of many commodities from oil to cobalt, and re-rate prices in the sector higher.  

Russia-Ukraine Escalation

This week, President Putin signed the decree approving the annexation of four Ukrainian regions (Donetsk, Luhansk, Zaporizhzhia, and Kherson), amounting to approximately 15% of the country’s area. Escalation in defense of “Russian territory” is a more significant risk than the market is pricing for the coming weeks and months as Ukraine continues its counter-offensive and other catalysts roll off the calendar. (Recall that Putin waited for the completion of the Beijing Winter Olympics to begin his “Special Military Operation.”)

What’s at stake?

Putin has ordered the Russian nationalization of Ukraine’s largest nuclear plant in Zaporizhzhia this week, and reports of Russian missiles hitting civilian and military targets in the region hit the newswire on Wednesday. Mounting counter-offensives from Ukraine across the territories could lead to further escalation by Russia. In the interest of defending land in the Russian Federation, the country’s articles of war or principles for engagement may allow for the use of more significant weapons against Ukrainian troops in the annexed areas.

NATO reported this week that Russia may be planning a major nuclear test near their border with Ukraine in the Black Sea, which the Kremlin has denied, but many news outlets reported the movement of nuclear weapon equipment by train toward Ukraine. We believe that the probability of a smaller tactical nuke being used in Ukraine, which has reportedly led to Kyiv distributing Potassium Iodide to its citizens, is being mispriced or at the very least, underappreciated in the market. Remember that the last nuclear test in the world occurred by the United States in 1992, and while the USSR conducted a test in 1990, the post-breakup Russian Federation has never performed one.

What it means for markets?

Significant geopolitical risk often begets a flight to safety – namely the US dollar and Treasuries – away from equities. Specific to this case, any nuclear attack by Russia would cripple relations between Russia and the West (and possibly the entire globe), resulting in less energy and metals making it out of the country, limiting supply, which would further weigh on economic output across the world, particularly in Europe.

Brazil Presidential Elections

In the first round of elections, former President Lula da Silva received 48.4% of the votes, in line with polls, while current President Jair Bolsonaro secured 43.2% of the vote, roughly 5% above polling numbers. The run-off election is scheduled for October 30.

What’s at stake?

Pro-Bolsonaro and right-leaning candidates did well in congressional races, gaining 22 seats in the House and guaranteeing his PL party would be the largest in both the House and Senate. Overall, the bi-cameral congress became less fragmented, but more polarized, which could make for a more oppositional congress in the event of a Lula win. We believe this result increases the probability of fiscal responsibility, regardless the result of the presidential race.

What it means for markets?

Given the increased probability of fiscal responsibility from both sides, we believe that once election risk passes and the final result is accepted by both the parties and general public, risk assets in the country should do well in the coming months.

US Midterms

Amid poor presidential approval ratings, United States midterms elections are slated to take place November 8 as a quasi-referendum on Biden’s presidency.

What’s at stake?

In the House, all 435 seats are up for re-election as they are every two years. FiveThirtyEight currently estimates that Republicans have a 70% chance of winning a majority in the House of Representatives, shifting control from Democrats and Speaker of the House, Nancy Pelosi.

In the Senate, 34 seats are on the ballot this year, with 15 currently held by Republicans, 13 by Democrats, and six seats open after senators announced they would not be seeking re-election. The current split of 50-50 slightly tilts to the Democrats, with Vice President Kamala Harris serving as the tie-breaking vote, and FiveThirtyEight currently gives Democrats a 2-in-3 chance of holding the senate, with an average number of 51 seats.

A split Congress often leads to gridlock, meaning Democrats would look to maximize use of the post-election lame duck period to push an expansive agenda while they still controlled both chambers.

What it means for markets?

Wharton professor Jeremy Siegel noted to CNBC that markets tend to perform well when there is political “gridlock”. Since 1944, the S&P has averaged a 13% annual return in calendar years with a Democrat president and split Congress. More immediately this fall, the debt ceiling debate, the potential for more fiscal spending toward monkeypox and hurricane aid among other things, and the possibility of more SPR releases to dampen inflation effects for a voter-base most energized by the economy have the potential to impact Treasury markets and oil markets, with a derivative impact on equity prices. Finally, while the Fed maintains an apolitical stance, a deluge of inflationary fiscal measures could influence its interest rate path, which could weigh on all asset classes.

OPEC+ Meeting & Further SPR Releases

After announcing 2mbpd cuts to quotas on Wednesday, which will amount to roughly 900k bpd of less production by OPEC+ members after accounting for missed quotas, the cartel announced that the current production agreement would be extended to the end of 2023 and that they would be meeting every two months in lieu of the current pace of monthly meetings. In response, the White House said that Biden would continue SPR releases as appropriate, with reports of another 10 million barrels being released in November to combat rising gas prices, again.

What’s at stake?

The Strategic Petroleum Reserve (SPR) is at its lowest levels since 1984, with the population of the United States approximately 45% higher, and the Biden administration has leased the fewest number of federal acres for energy production through 19 months in office since Harry Truman in 1945-46, when offshore drilling was new and the federal government didn’t control deep-water leases that make up the largest part of the federal oil-and-gas program today. OPEC+, citing a potential global slowdown and less directly, a dissatisfaction with the price of oil, opted to decrease production as the US has either intentionally or unintentionally massaged prices lower through oil releases. Most of the actual production cuts will come from Saudi Arabia, and interestingly enough, Business Insider reported on Thursday that the kingdom had lowered oil prices for Europe but raised them for the United States. The administration appears to be gambling that SPR releases will help their prospects in the midterm elections, while at the same time playing chicken with OPEC+ on production, decreasing the country’s ability to manage in the event of any positive oil demand shock.

What it means for markets?

With interest rates marching higher increasing the cost of capital and the green lobby in DC targeting oil and gas companies, domestic producers have not been quick to bring more wells back online. Any rebound in Chinese demand, or a ban on domestic exports, could result in a significant increase in the price of energy at a time when domestic production is lacking and disincentivized from growing. Energy prices are a natural pass-through to virtually everything, raising the floor on commodity prices and potentially re-accelerating inflation which could possibly lead to more hawkish monetary policy in the US. Such a move would not only weigh on equity prices, but also be a tailwind to the US dollar in the event that other central banks have less latitude to tighten. Further tightening by other central banks, namely the ECB, could push those countries deeper into recession and further weigh on both global growth and markets.

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Macro Minute: Dollar dollar bill, y’all

This past Friday, September 9th, Bill Dudley was on air early morning making the case that the Fed wants a strong dollar. We know very well why the Fed needs a strong dollar. We wrote on July 25th about the relationship between inflation expectations and the currency’s strength:

“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. 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.”  – Macro Minute: We Learn From History That We Do Not Learn From History. July 25th, 2022.

However, how long the Fed can enjoy this position is less clear. Free-floating exchange rates, as opposed to the traditional view that expects a move to equilibrium at fair value, are inherently unstable. The reason for that is the reflexive nature of exchange rates. A change in exchange rates affects inflation, interest rates, economic activity, and other fundamental factors that then have an impact on exchange rates. This effect creates self-reinforcing and self-defeating processes that are very pronounced in currency markets.

In the case of the US dollar today, the fundamentals and nonspeculative transactions point in the direction of depreciation. It is only when looking at speculative transactions that we can find an explanation for the strength of the dollar in the past 12 months. In reality, the classification of speculative and nonspeculative is much more subtle, but for the purposes of this analysis, a simplified version of the model should suffice.

Non-speculative capital flows arise from the need (not the choice) to buy or sell dollars. On this account, all the fundamentals point towards the depreciation of the US dollar. The need to finance the US twin deficits is not new, but it has increased meaningfully recently. But one component in particular is seeing the largest changes- the need for USD in commercial transactions. Charles Gave, co-founder of Gavekal, wrote an excellent piece on “Network Effects and De-globalization.” In it, he proposes that reserve currencies benefit from the network effect, and that the turning point for the demand for US dollar transactions happened when the US insisted upon oversight of all US dollar transactions anywhere in the world. He argues that the catalyst for accelerating the contraction of this network was the US sanctioning Russian assets earlier this year. This decline has so far been masked by an increase in demand for USD coming from the energy crisis in Europe. We agree with that analysis and we can see the relationship between natural gas prices in Europe and the EURUSD (inverted axis) pre and post-mid-2021 below.

Speculative capital, on the other hand, is attracted by rising exchange rates and rising interest rates. Of the two, exchange rates are by far the most important. It does not take very large movements in exchange rates to render the total return negative. In other words, speculative capital is motivated by expectations of the exchange rate, a reflexive process. And when markets are dominated by speculative flows, they are purely reflexive. This is a very unstable situation. The self-reinforcing process tends to become vulnerable the longer it lasts, and it is bound to reverse itself, setting in motion a process in the opposite direction.

This is an obviously oversimplified model, but it brings useful conclusions. When the inflow of speculative positions cannot keep pace with the trade deficit, rising interest obligations, and lower demand for trade in US dollars, the trend will reverse. When that happens, the reversal may accelerate into freefall, as the volume of speculative positions is poised to move against the dollar not only on the current flow, but also on the accumulated stock of speculative capital. Lastly, when that happens, the exchange rate will have an impact on fundamentals (inflation and inflation expectations) which in turn will have an impact on exchange rate expectations in a self-reinforcing process. All of this will make the Fed’s job that much harder.

Given the unpredictable nature of speculative flows and self-reinforcing trends, we can’t say for certain when this will happen, but if pressed for an answer, I would say in the next 9 months. If the US dollar maintains or accelerates its trend during this period, the EUR would have to be trading below 0.86, the JPY above 170, and GBP below parity. And if it doesn’t, the reversal would be dramatic, if not catastrophic.

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Macro Minute: The Changing Colors of Politics

On the artist’s color wheel, red and green are considered complementary colors, diametrically opposed from one another but known to harmonize when used together. However, for at least a decade, the biggest political proponent of green energy in America has been the “blue” Democratic Party.

The administration’s most recent spending bill, The Inflation Reduction Act of 2022, has been heralded as a huge leap forward for renewable energy in the United States by Democrats, but was opposed by every Republican in the House and Senate. A closer look at where renewable infrastructure is being built, thereby creating jobs and increasing investment, demonstrates that while on Capitol Hill, the reds may be diametrically opposed to green legislation, red and green may actually be quite complementary. We believe that green investment will have meaningful repercussions come election season for years to come.

In our 2021 Annual Report, we discussed how our most probable scenario for achieving net-zero by 2050 would require expansive transmission and generation infrastructure to be built in the American heartland, primarily in traditionally Republican states. In turn we suggested that the development of said infrastructure would result in significant job creation and local investment, that would lead to one of two outcomes – more bipartisan support for investment in green infrastructure as Republicans acted in the interests of their constituents or a change in voting patterns by those being positively impacted by investment and new jobs.

A 2014 study by the University of Maryland found that a $1 spent on infrastructure investment added as much as $3 to US GDP[1] and suggested that the effect could be even larger in a recession. Historically, state and local governments have borne the majority of costs for spending on infrastructure – since 1956, they have been responsible for approximately 75 percent of spending on infrastructure. In that time frame, federal infrastructure spending has increasingly become a smaller percentage of the overall budget.

When the federal government does spend, it is typically through capital investment for new projects or modernization. The nonprofit, nonpartisan Tax Foundation estimates $116 billion of new energy and climate spending, excluding tax credits, from the newly passed legislation.[1] Including leverage available through components of the bill like the Energy Infrastructure Reinvestment Financing program, which provides $5 billion to finance up to $250 billion in projects for energy infrastructure, including repurposing or replacing energy infrastructure, takes new spending to more than $300 billion over 10 years. The last Congressional Budget Office estimate for federal government infrastructure spending was approximately $98 billion per year, meaning the bill would increase spending by around 30% annually, excluding tax credits that will encourage more private investment. Why is this important? Using percent changes in GDP, inflation, and the S&P 500 as barometers for economic conditions, Lewis-Beck and Martini[2] demonstrated the existence of a map from real economic conditions, to voter perceptions, to vote choice. Put simply, voters’ evaluation of the economy is real, and they punish or reward the incumbent candidate based on these conditions.

Bloomberg recently ran an article titled ‘Red America Should Love Green Energy Spending’, showing where a bulk of renewable infrastructure is being built. There are 435 congressional districts in America. 357 have planned or operating solar plants, with 70% of the power capacity found in republican districts. 134 have planned or operating wind plants, with 87% of the capacity found in red districts. Lastly, 192 have planned or operating battery storage facilities, with 58% of the capacity in right-leaning districts. Of the top-10 districts with planned or operating renewable infrastructure, nine are currently Republican-held seats, and within that group, 86% of total capacity is found in Republican districts.

So why might Republicans who are overwhelmingly benefiting from job creation and investment in green infrastructure be against such legislation? First, some of the capacity listed is planned, and has yet to filter through into the local economies they represent. Second, there are elements of both NIMBY-ism and extreme partisanship throughout the country on both sides that lead people to immediately dismiss ideas from “opposing” parties. But most obvious to us is that Republicans also overwhelmingly represent areas with the most emissions. 80% of the top-100 emitting districts are represented in Congress by Republicans, including eight of the top-10.

n the 2020 election cycle, fossil fuel companies spent $63.6 million lobbying Republicans compared to $12.3 million for Democrats, and since 1990 the industry has spent approximately 4.3 times the amount lobbying for Republicans than Democrats. In other words, support for green investment will ultimately come at a cost for the party. However, a myriad of studies have demonstrated that infrastructure investment boosts productivity over time and the literature shows that this will ultimately have an impact on voter preferences. Voter preferences fundamentally drive political rhetoric, so as green infrastructure investment becomes more pervasive, particularly in red states, we expect an increasing impact of renewable energy development on elections. 

[1] Werling and Horst. “Catching Up: Greater Focus Needed to Achieve a More Competitive Infrastructure.”

[2] https://taxfoundation.org/inflation-reduction-act/

[3] Lewis-Beck C, Martini NF. Economic perceptions and voting behavior in US presidential elections. Research & Politics. October 2020. doi:10.1177/2053168020972811

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Macro Minute: GDP Deep Dive

Last week, just before the end of the month, we got the Second Quarter Advance GDP Estimate from the US Bureau of Economic Affairs (BEA). The quarter-over-quarter annualized number for real GDP printed a disappointing -0.9%, compared to a median expectation of +0.4%, but still better than the 1Q number of -1.6%. 

GDP releases are very important events for markets. Companies use them to help make investment decisions, hiring plans, and forecast sales growth. Investment managers use them to refine their trading strategies. The White House and Federal Reserve both use GDP as a barometer for the effect of their policy choices. 

These numbers are especially important for turning points in the economy. For some (but not the National Bureau of Economic Relations – the US agency responsible for classifying recessions), two consecutive quarters of negative real GDP growth is defined as a recession. If we took the early GDP releases at face value, this would imply that we are in a recession today, dating back to the first quarter. For all the above reasons, it is worth digging into how the BEA derives this number and how reliable the early releases are.

One of the tasks of the BEA is to calculate US GDP, measured as the total price tag in dollars of all goods and services made in the country for a given period. It is the sum value of all cars, new homes, lawnmowers, electric transformers, golf clubs, soybeans, barbeque grills, medical fees, computers, haircuts, hot dogs, and anything else sold in the US or exported during the period. When calculating current (or nominal-dollar) GDP, the agency adds the value of all goods and services in current dollars. But this herculean task does not end there, because what matters for most people is the real growth in the economy. And so, after tallying up everything in current dollars, the agency has to then make adjustments to try and come up with an estimate of the value of what was actually produced in the economy (e.g., ex-inflation). 

Imagine an economy that only produces two things, potato chips and mobile phones. Suppose that the economy is selling $1.1 million of goods this year, an improvement of 10% compared to the $1 million from last year. That $1.1 million number represents the nominal GDP for the economy this year. But that number does not tell us how much of that 10% increase is due to more goods being sold and how much derives from price increases. 

If last year there were 50,000 bags of chips sold for $10 and 500 mobile phones for $1,000, and this year there were 55,000 bags of chips and 550 mobile phones sold for the same price as last year, the economy had real growth of 10% and zero percent inflation. 

Alternatively, if this year the economy sold the same number of chips and mobile phones as last year but did so at a price of $11 and $1,100, respectively, the economy had zero real growth and 10% inflation. 

However, things are not so simple, for the methodology is designed not only to remove price inflation but also to adjust for the quality of the goods being sold. Let’s assume that this year the economy sold 55,000 bags of chips for $10, and 550 phones for $1,000 (the same as the first example). But in this example, the bags of chips sold this year only contain 40 chips versus the 50 chips in each sold last year, and the mobile phones sold this year have better computational power and an extra camera versus last year’s. In this case, the agency would have to account for those changes by calculating a positive price increase for the potato chips and a negative one for the mobile phones, even though the number consumers saw on the price tag did not change. Now imagine that the BEA must do this not just for all the goods sold in the US economy, but also for every service provided, and to deliver an advance estimate one month after the end of a quarter. 

Which brings us to the question, how reliable are early GDP estimates? The answer is… it depends. Each revision incorporates more and better data and is believed to be a better estimate of the true value of GDP. For example, comprehensive data accounts for only 25.5% of advance estimates and 36.8% of second estimates, but it accounts for 96.7% of what we can call “final” estimates[1].

To assess the reliability of the GDP estimates we can look at revision patterns to understand if there is a bias in these revisions and how large they can be. To assess bias, we calculate Mean Revision (MR) where components tend to be offsetting and a large positive or negative number would indicate bias. To understand how large revisions can be, we calculate the Mean Absolute Revision (MAR) and the standard deviations, which are both complementary measures of the distribution for the revisions around their mean. We calculate these revision metrics for the Advance release that comes out one month after the end of a quarter, comparing with both, the Second releases (two months after the end of a quarter) and what we here call the “final” estimates (also called, comprehensive revisions, which are released approximately five years after the advance release).

What we find is that inflation has a meaningful impact on reliability. More specifically, it creates a pronounced bias for advance releases in underestimating real GDP growth. This makes intuitive sense. The task of calculating real GDP becomes even more challenging during inflationary environments. Looking at the numbers, we find that in periods of low inflation [3,4], bias is virtually inexistent with MRs for Second and Final at +0.10% and -0.01%, respectively. While during periods when US CPI is above 7%, MRs are +0.40% and +0.80%, respectively. That means that, on average, in high-inflation environments, Advance GDP numbers are underestimated materially. It is also important to note that MARs and standard deviations are essentially unchanged from one environment to another. This means that the size of revisions is similar in both circumstances. 

To clarify the point, let’s look at last week’s 2Q 2022 GDP Advance release of -0.9%. We can say that the second estimate will be between -1.5% and +0.4%, while the final estimate will be between -2.6% and 2.4%, with 90 percent confidence. This distinction between inflationary and non-inflationary environments is important because if we used the low-inflation scenario numbers, we would say that the second estimate would be between -1.9% and +0.2%, while the final estimate would be between    -3.6% and +1.7%, with 90 percent confidence. [5]

One way to increase the reliability of activity numbers is to look at the average of GDP and GDI. In theory, GDP and GDI should be equal, but in practice, GDP and GDI differ because they are constructed using different sources of information – both are imperfect in different ways. If both GDP and GDI are interpreted as the sums of unobserved, true economic activity and measurement errors, it is possible to infer that the weighted average series of the two is a more reliable measure of activity than either GDP or GDI alone, assuming some of the measurement errors are averaged out.

In short, calculating GDP is a mammoth undertaking, early estimates of real GDP tend to underestimate growth in inflationary environments, and you are better off taking a holistic view of the economy when data is as volatile as it is today. 

P.S. We talked a lot about real GDP, but we should not neglect nominal GDP. Historically, S&P earnings growth tended to stay in line with nominal GDP. And that is how corporate sales, revenues, and profits are recorded. In the second quarter of 2022, nominal GDP in the US was approximately +7.9% QoQ annualized.  

P.P.S. For a depiction of how and when GDP revisions and their vintages are made and maintained by the BEA, please see below.

[1]  Comprehensive revisions are performed every five years and include major updates to classifications and definitions for the entire GDP time series – for more information, please see the endnote

[2] Holdren, Alyssa – Gross Domestic Product and Gross Domestic Income – Revisions and Source Data (June 2014)

[3] Fixler, Francisco, Kanal – The Revisions to Gross Domestic Product, Gross Domestic Income, and Their Major Components (June 2021)

[4] Using 1996-2018 period used in above paper, when US CPI inflation averaged 2.2%

[5] Revisions follow a normal distribution and therefore we can calculate the combined probability that the true value of real GDP growth in the 1Q and 2Q was below zero, i.e., two consecutive quarters of negative GDP growth. P (2Q < 0% | 1Q < 0%) = 36%.