The Fed has been here before, when forward expectations of the funds rate are collapsing towards the spot rate. How the FOMC chooses to react will greatly determine whether the expansion continues or rolls into recession. The choice will be to pause: there is no inflation surge to chase down and there are headwinds aplenty. Whether pausing and guiding forward rates lower can stabilise and then renew the equity market uptrend, as it did in 2016 and 2017, is not assured.
Equity investors could be most concerned about the headwinds beyond the Fed’s direct reach, such as global weakness (including China) and uncertainty (Brexit, Italian budget, French taxes, German politics), After all, US economic data still very much point towards 2%-2.5% growth, although whether even this is sustainable is being questioned. What markets are essentially relaying to the Fed is, in our view, that it is a mistake to set policy against normal cyclical benchmarks when the US and global economies are adjusting to the return, after a long decade, of US dollar money market yields as a real cost and a viable asset class.
Ten years is a long time. A lot of people working today have never had a short rate appreciably above zero to consider. Many of the risk opportunities and asset allocations put in place during this past decade make far less sense today, and new capital flows will consequently be moving in different directions. This transition to “normal” money market rates has effectively put the economy into a more uncertain position, revealing underlying fragilities (corporate leverage for one) even though the price of money, at around 25 basis points in real terms, is far from contractionary.
Since the unwinding of the great zero interest rate policy era began in December 2015, there have been two episodes of curve compression: the first half of 2016 and late summer 2017 (chart above left). On both occasions the Fed chose to stop raising rates and manipulated term yields by lowering forward policy projections (chart above right). Capital markets responded and the economy continued to expand.
What makes the current episode different from these prior two, or even from 1995, is that the market is today forecasting a drop in the funds rate two years out. The mathematics of this expectation of a fall beginning in mid-2020 translates into the 2s/5s yield curve slipping into negative territory (see chart above).
When the Fed chooses to ignore inversion, recessions ensue. This was true in 2006 and 2000 (chart below) and in 1990 as well. The reason inversion creates recessions is that when shortterm riskless assets yield as much as, if not more than, risk assets, money moves to cash and liquidity to fund credit consequently dries up – and so begins an expansion’s end.
Is recession now inevitable given this tiny inversion of the 2s/5s yield curve? Has the economy’s transition therefore become an outright turn of direction? Some damage has been done by the stock market’s swoon, even though it will take time to become evident in real activity, but recession is hardly inevitable. While Powell refuses to be the market’s nanny and quash its function of price discovery, he also recognises that the process of unwinding a decade of activity tied to zero rates is neither short nor painless.
The Fed will stop hiking and will lower forward guidance, but, given the level of rates, the transition period that has begun will continue both in the US and elsewhere in the world. Markets will consequently stabilise but remain volatile while traditional economic guideposts will prove less valuable. Risks abound. As a result, the stakes for policy to get it right are high - in the US as well as in China and Europe.
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