December is nearly upon us, but the sound of jingling bells cannot be heard within the halls of the Fed, as this band of banking buddies considers the plight of raising rates and shrinking its balance sheet at the same time. Normalization is the word for the day, at least for this holiday season, when the Fed must decide, as it has in the past, to hike its benchmark rate ranges before Santa can even board his sleigh. New economic and job data are at hand. Our perilously low interest rates must rise at some point, but can policy changes save us from the consequences of an extended period at near-zero levels?
We are now a decade into this new era of “creative” central bank policy making on a globally coordinated basis. What started as a crafted jolt of liquidity to stimulate a radical rebound to economic stability has now morphed into a ten-year program with no end in sight. What was supposed to be short term in nature, since nearly everyone and their grandmother predicted rampant inflation as a consequence, has become a plan with no clear exit strategy. Reliable indicators and guideposts now send mixed signals, and the financial gurus of our times do not have a clue as to how to proceed.
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Janet Yellen, our current Fed chairperson who will soon be replaced by an even more dovish candidate, if that is possible, is simply perplexed by the current situation. In a recent public speaking engagement, she expressed her uncertainty and that her key lessons have been to “keep an open mind and not assume you have a monopoly on truth.” She concluded that, “It may be that there is something more endemic going on or long-lasting here that we need to pay attention to.” We are in uncharted territory, and the sooner we accept this unsolved mystery, the better.
What have been the consequences of decade-long low interest rates?
If we return to “Economic 101”, basis economic theory suggests that lowering interest rates will force investors to take more risks, flooding the engines of commerce with additional capital that will be used to produce more goods and, consequently, more GDP growth. With enhanced growth, wages expand, spending ensues, and inflation heats up, until interest rates are raised to cool down the engine, once more. The logic sounds, well, logical, but no one anticipated the degree of a supply glut that existed on all fronts and how much over-supply the new stimulus would create.
What was needed was more demand, not supply. Cheap capital flowed down every corridor unimpeded, as one economist opined: “Low to negative interest rates are a distortion of markets that imply a fundamental misunderstanding of the purpose of markets, which is to efficiently allocate capital. When savings generates a negative return, as they do when bonds and bank accounts charge rather than pay interest, capital shrinks rather than grows. There is no possibility of “efficient allocation” when returns are negative.”
When growth and inflation never resulted from these global policy decisions, primarily made in developed economies where the so-called gurus resided, central bankers decided that more was better. Consistently low interest rates forced investors to chase higher-risk returns across the globe, more than likely in developing and emerging economic regions graced with natural resources. Commidity prices plummeted from over supply, while savers “lost about $7.7billion in the past decade due to low interest rates”, as the above pictorial illustrates.
The consequences also tend to be more over-arching, i.e., not just a monetary impact on savers. Here are a few quotes from the central banking community across the planet, which is just as confused as we presently are with the current turn of events:
- Persistent Distortions: “Asset prices are bid up; risk-taking is encouraged; projects are undertaken that would not be viable with normal interest rates; balance sheet valuations are muddled; and pension plans are put in disarray. Central banks have to weigh the benefits of stimulatory settings against these distortions.”
- Inflation Guidance Conundrum: “Conventional inflation targeting relies on using inflation as the indicator of when the economy had reached full capacity. Without this, inflation-targeting central banks don’t have a simple indicator for policy tightening. The answer is that central banks should look at a wider range of indicators. To use inflation prospects as the sole criterion for policy setting was always a convenient simplification. Now central banks need to add other indicators of economic slack.”
- Stabilization is Key: “The ultimate aim of monetary policy is not to achieve a particular inflation range, but to help stabilise the growth of output and employment. Targeting consumer price inflation has been found to be a useful way of doing that, but it is not actually the final objective.”
- Extended Low Interest Rates are Risky Business: “The important decision framework is the trade-off between the risks to future financial stability that arise from leaving rates very low in a period of rising market confidence, and the risks that somewhat higher interest rates will slow the rate of growth of output while there is still spare capacity in the economy. It’s a tough decision with something to be said on both sides, and it is being debated in most central banks.”
Where are we nine years after the great meltdown? Debt levels are high everywhere. Asset bubbles abound, especially in real estate, once again, as before. There is little tolerance in this picture for rising interest rates, but rates will eventually rise. Attempts to stoke the present economy may only exacerbate current symptoms and expose the many areas that are vulnerable to rising debt service scenarios. The Fed and others must, however, prepare for the inevitable. Their respective “toolboxes” are now near empty, thereby suggesting that the path may continue to be low and slow for several years to come. In the meantime, the current yield curve is cause for concern.
A flattening to inverting yield curve is a recession indicator that cannot be ignored
There has been much talk in the financial press about a flattening yield curve over the past year. Just for the record, here is a brief description of the phenomenon: “Historically, an inverted yield curve has been viewed as an indicator of a pending economic recession. When short-term interest rates exceed long-term rates, market sentiment suggests that the long-term outlook is poor and that the yields offered by long-term fixed income will continue to fall.”
Interest rates typically increase over time as maturities lengthen, such that a rising curve is one obvious portrayal from a picture perspective. As short-term uncertainty grows, the lower maturity securities must pay more in order for demand to increase, a process that makes the curve suddenly begin to flatten over time. Analysts that focus on the bond market religiously follow the goings on in this area, plotting not only curves for government offerings, but also extending the review to corporate issues, swaps, and various options.
The track record for these types of analyses when it comes to predicting a recession is, in a phrase, off the chart. The best way to observe how this leading indicator has played out in the past is to record the margin or spread between 10-Year and 3-Month notes, as presented in the following diagram:
The horizontal line with a value of “0” denotes a “flat” condition, i.e., values for both securities are equivalent. When the “spread” becomes negative, alarm bells should begin ringing. Before every one of the eight recessions since 1960 (shown in blue columns), the yield curve spread had turned negative 100% of the time. In fact, there was only one contrary signal back in 1966 when the margin hit negative territory, but no recession was recorded.
The Sixties were a strange period, indeed, but the reliability of this indicator is astounding, no matter how you might want to discount it. What has been the more recent trajectory? Spreads have been in decline since 2010, more attune to a rollercoaster ride, if you will, but 2017 has witnessed a full percentage point drop in one year, now resting at a one percent value. Can the spread figure drop into the negative region in the span of a single year? Look at 2000 and 1989, or even further back, if you wish for more confirmation. Is this indicator to be ignored? Is it subject to the same constraint, i.e., current central bank policy entanglements, that has rendered other time-honored leading indicators to the trash heap of late? Is that a bet you want to make?
What are central bankers saying about the future recession to come?
Fed governors have already been on the speaking trail, espousing their personal concerns over how the world will deal with the next monetary crisis. John Williams, the San Francisco Fed President, recently noted, “Global central bankers should take this moment of “relative economic calm” to rethink their approach to monetary policy.” He also warned that, “To fight the next recession, as with the last, they would need to do more than just cut interest rates.”
Charles Evans, the President of the Chicago Fed, has stated that higher inflation targets must be telegraphed, more in the 2.5% level and higher, but, he, too, senses that something new must be tried: “Strategies that central banks should consider including not only the bond-buying and forward guidance used widely in the last recession, but also negative interest rates that was used in some non-U.S. countries, as well as untried tools including so-called price-level targeting or nominal-income targeting. Price-level targeting, since it focuses on the wrong prices, will simply blow up even bigger asset bubbles.” Do you detect a bit of groping for the handrails by these esteemed bankers?
We are approaching December, traditionally a time of good cheer, but one that for the last two years has also been a pivotal moment for the Fed to impart its wisdom or lack thereof upon the public at large. One analyst summed it up this way: “The list of delusions and other pathologies could go on for a while. Suffice it to say that when the next recession hits – which, based on the action in junk bonds, sub-prime mortgages and the yield curve, may be fairly soon – some truly crazy ideas will be dumped on a still (amazingly) unsuspecting public.”
General interest rates are rising, if only slightly. The yield curve is also flattening, ever so slightly, as well, but are alarm bells ringing? The only certainty is that rates will rise to a new normal, but what is that?