Macro Battleship with Christopher Wood

I remain firmly of the view that the next move in interest rates in the U.S. will be a cut, not a hike. The view here also remains firmly that the way the U.S. yield curve steepens going forward will be by short-term interest rates falling, not by long-term bond yields rising.

All of the above raises the issue of the potential for a further deceleration in the U.S. economy, the threat of which has been signalled by the flattening of the U.S. yield curve for the past two years (see following chart) and by the rally in the U.S. Treasury bond market since October 2018 when, to the surprise of the vast majority of talking heads featured on the obvious TV business channels, the ten-year bond yield did not break above the trend line in place for almost 38 years since the beginning of the current bull market in Treasury bonds in 1981 (see following chart).

U.S. 10Y-2Y Treasury bond yield spread

US 10Y-2Y Treasury bond yield spread

Source: Bloomberg

U.S. 10-year Treasury bond yield (log scale)

U.S. 10-year Treasury bond yield (log scale) - Apr 2019

Source: Bloomberg

The failure to break above that trend line, despite the sugar rush impact of Trump’s tax reform, is the most important thing in financial markets that could have happened last year that did not happen. It is also worth noting that, despite the massive rally in Treasury bonds, speculators are still net short the 10-year Treasury futures, though the number of “shorts” is way down from the peak reached last September. The speculative net short position on 10-year Treasury bond futures rose to a peak of 756,316 contracts in late September 2018 and is now 261,564 contracts (see following chart).

CFTC CBT U.S. 10Y Treasury note futures net speculative (non-commercial) long positions

CFTC CBT U.S. 10Y Treasury note futures net speculative (non-commercial) long positions

Source: Bloomberg, Commodity Futures Trading Commission (CFTC)

Can Bullish Bonds Signal an Economic Slowdown?

The bond market is, 90% of the time, more right than the stock market about the economy.

Such bullish bond market action is sending a powerful signal of a U.S. economic slowdown. This should be respected since the bond market is, 90% of the time, more right than the stock market, even despite all the current fashionable theories about government bond markets being distorted by years of quanto easing. Meanwhile, it is also the case that Jerome Powell was ignoring the flattening yield curve last year at his potential peril before the spike in credit spreads last December precipitated the “Powell pivot”.

From my personal point of view, Powell’s efforts to normalize U.S. monetary policy since he assumed the Fed chairmanship in February 2018 have been commendable in the sense that interest rates have been raised more than would have expected when Janet Yellen began rate hikes in December 2015 while the Fed balance sheet has actually contracted. But this is from the standpoint of an observer who does not believe in the quackery of quanto easing, and who also does not believe that “deflation”, in the form of negative CPI, is the root of all evils that has to be avoided at all costs, even to the point of totally manipulating the market level of interest rates.

 

Has Monetary Tightening Damaged the U.S. Economy?

The academic eggheads who currently dominate the intellectual debate at the Fed, influenced as they are by both monetarist and Keynesian stereotypes, believe that deflation is to be avoided at all costs. For such people the flattening yield curve last year, combined with the continuing failure of the Phillips curve to work as it is meant to be, constitute warning signals that the Fed has been over tightening. And indeed, by their own standards, the Fed has “over tightened”. The result was the “pivot” when market symptoms of excessive monetary tightening (ie, rising credit spreads) emerged.

This then raises the issue of how much damage has already been done to the American economy by the monetary tightening cycle, and here it should be remembered that while the Fed appears to have stopped tightening, it has not yet commenced easing. On this point, it should also be stressed that, while short-term interest rates in the U.S. remain in absolute terms low, the monetary tightening in this cycle is by far the greatest in American history in terms of the percentage increase in short-term interest rates from the absolute low. Thus, in the period between December 1976 and March 1980 the Fed raised the Fed funds rate target by 15.25ppt or 321% from 4.75% to 20%. By contrast, the Fed has raised the Fed funds rate target range since December 2015 by “only” 225bp from 0.0%-0.25% to 2.25%-2.5%. But this translates into a 1,800% increase based on the midpoint of the Fed’s target range, or 900% based on the upper bound of the range (see following table).

Changes in Fed funds rate target during Fed tightening cycles

Tightening periodFrom (%)To (%)ppt chg%chg
Mar-71 – Aug-733.5011.007.50214%
Mar-74 – Jul-749.0013.004.0044%
Dec-76 to Mar-804.7520.0015.25321%
Aug-80 to Jun-819.0020.0011.00122%
Dec-86 to Feb-895.889.753.8866%
Feb-94 to Feb-953.006.003.00100%
Jun-99 to May-004.756.501.7537%
Jun-04 to Jun-061.005.254.25425%
Dec-15 to Dec-18 (Upper)0.252.502.25900%
Dec-15 to Dec-18 (Mid)0.1252.3752.251800%
Dec-15 to Dec-18 (range)0.00 – 0.252.25 – 2.502.25

Source: Federal Reserve Bank of New York, Federal Reserve

It is also the case that while the Fed has now announced that it will stop balance sheet contraction at the end of September, the fact is that the American central bank’s balance sheet will have contracted by then in aggregate by US$785 billion or 17% from the peak level reached in 2015 (see following chart). There is, seemingly, no historical precedent for a central bank liquidating that amount of assets, and so the consequences of such an action are hard, if not impossible, to assess.

Federal Reserve balance sheet reduction plan

Federal Reserve balance sheet reduction plan - Apr 2019

Source: Federal Reserve

The above is why there is a real risk of the U.S. economy surprising to the downside in coming quarters, starting with this quarter. This is despite the seeming strength of U.S. payroll and wage data which, it should be remembered, are classic “late cycle” indicators and not leading indicators. Thus, the classic interest rate-sensitive sectors, namely housing and auto, remain weak. New home sales are still 6.3% below the recent high reached in November 2017. While the pending home sales index of existing homes is now 9.7% below its recent high reached in April 2016 (see following chart).

US new home sales and pending existing home sales index

U.S. new home sales and pending existing home sales index

Source: U.S. Census Bureau, National Association of Realtors