An Inverted Yield Curve: What's It Mean?
As early as December 2017, market analysts began commenting on the U.S. Treasury yield curve’s flatter nature throughout 2017. By the Summer of 2018 warnings of the impending inverted yield curve really ramped up, but with a different connotation. Last Summer many market watchers characterized the inverted yield curve as a nearly perfect historical indicator of an imminent recession.
On December 3rd, 2018 the U.S. Treasury 3’s/5’s spread inverted. The last time that happened was August 2008. Soon thereafter the Eurodollar futures market also inverted. Previously the Fed had commented that the inverted yield curve wasn’t so much a worry because of the extenuating circumstances in the global capital market. Instead, investors should focus on comparing the difference in yields between short-term Treasuries and the yield implied by futures markets for the same bills six quarters later. Now that such inversion has happened, what’s next?
In its simplest form, the yield curve describes the relationship between yield, in terms of internal rate of return on a bond, and its maturity. Before the consideration of inflation, the yield curve describes the before tax, default-free, real interest rate for various lengths of time.
The academic paradigm states the linkage between a 1-year Treasury and a 3-year Treasury is the forward rate or the rate that must prevail three years from now to equate to the yields on tandem purchases of 1-year Treasuries to the yield on a 3-year Treasury, or three 1-year Treasuries all stack on top of each other. The spread between two maturities is the sum of a) the liquidity premium; and b) interest rate forecasts, or expectations. In general, an investor requires a larger liquidity premium over a longer investment horizon as compensation for taking on the risk of unforeseen changes in yields.
Generally speaking, two levers affect the shape of the yield curve: 1) The Federal Reserve’s sentiment, and 2) Investor sentiment. Fed sentiment controls the short-end of the curve based on their efforts to control and promote employment. During economic booms short-term rates are hiked and vice versa. Investor sentiment controls the long-end of the curve. In economic booms, investors rotate out of low-risk assets (government securities) and into riskier assets to take advantage of growing profits. Lower demand for low-risk assets causes long-term rates to rise. The same is true in the other direction.
Is the Inverted Yield Curve an Indicator of Recession?
No
According to a research paper published by the Federal Reserve Bank of St. Louis the standard asset-pricing theory tells us that the various real interest rates (adjusted for inflation) on the yield curve are indicators of how consumption is expected to grow over a given horizon. A high 1-year yield signals high expected growth over a 1-year horizon, and a high 10-year yield signals high expected growth over a 10-year horizon. Further, if the difference between the 10-year and the 1-year yield is positive then growth is expected to accelerate. If the difference is negative then the yield curve inverts and growth is expected to slow down. If an inverted curve indicates decelerating growth then the deceleration will entail moving from a higher-growth state to a lower growth state. If the lower growth state is near zero then growth is more likely to turn negative in the event of an economic shock. In this way, an inverted yield curve does not forecast a recession, it forecasts the economic conditions that make a recession more likely.
In the BlackRock Blog post entitled “What the Flattening U.S. Yield Curve Means”, author Richard Turnill states “The flatter yield curve is not a recessionary signal.” Instead, Turnill attributed the flattening curve to a reversal of the 2016 yield curve steepening that took place soon after the presidential elections. The effect of that election was produced by a surge of positive belief about economic growth and thus inflation. “Markets had bet that fiscal stimulus and infrastructure spending would spur growth and inflation, causing long-term yields to climb.” The flattening, according to Turnill, was an unwinding of those growth and inflation expectations throughout 2017 while persistent demand for longer-term Treasuries remained.
Other market watchers say current yield spreads aren’t a reliable indicator of future growth, because larger scale bond purchases by the Fed, BOJ, and the ECB have depressed long-term rates while the Fed is increasing its policy rate. In a July 2018 Wall Street Journal article entitled, Widely Watched Recession Signal May Be Falsely Lit By Growth, author Akane Otani writes, “Conventional thoughts about an inverted yield curve stem from two different paths coming together. Investors see longer-term bond yields climbing during strong growth and short-term ones rising when monetary policy tightens. When the gap narrows, questions are raised about whether the expansion has run its course. However, many other monetary experts say the recent flattening has been driven by monetary policy and continued growth, not fears of recession. Low bond yields in Europe and Japan, as well as fears of a U.S./China trade war, have spurred investors to buy U.S. treasuries, driving their value up and yield down.” Otani goes on to say, “According to Credit Suisse, recessions have historically followed not just an inverted yield curve but also a marked deterioration of in job creation and corporate earnings.”
Alex Gurevich of San Francisco based HonTe Investments, says, “The yield curve does not carry any new information, but is based on information that is already available and actually does not say anything new to us. It’s more a product of the inputs. However, it is true the curve tends to be flat when we go into the late cycle. It actually stabilizes in the late cycles. In the past few recessions the curve has refused to invert too deeply just as everyone is calling for inversion. And then, when the Fed actually starts cutting rates, a very rapid steepening and sometime logic-defying steepening starts to occur.” Gurevich’s central idea is that yield curves don’t reflect anybody’s P&L. Only total return charts matter for interest rate instruments, and fully funded total return.
Yes
On the other side of the argument is James Bullard, Chairman of the St. Louis Federal Reserve Bank, and others. In a 3Q18 memo entitled The Risk of Yield Curve Inversion and How to Avoid It, Federal Reserve Bank of St. Louis Chairman James Bullard stated, “the potential for a yield curve inversion is a key issue in U.S. monetary policy in the near term.” Chairman Bullard goes on to claim that inversion is troubling since historically the yield curve has been bearish signal for the U.S. economy and helps to predict recessions. Furthermore, Bullard suggests that an inverted yield curve indicates that the Federal Reserve and the financial markets have different outlooks for the U.S. economy, since the 10-year yield is determined largely by market forces whereas the 1-year yields are mostly determined by the Fed’s policy rates.
Another macro analyst citing the historical relevance of the inverted yield curve is Dr. Lacy Hunt, from Hoisington Investment Management. Dr. Hunt states, “a flatter yield curve has occurred prior to every U.S. recession since 1942.” Dr. Hunt further claims that, “yield curve inversion is a leading economic indicator and is indicative of monetary restraint being well entrenched in the financial system. The process typically develops prior to showing up in economic data”.
In a July 2018 article in the Wall Street Journal entitled, “What the Fed is Missing, Again, author Justin Lahart spells out the importance of the yield curve. “The yield curve is important for the signals it sends about the future of the economy. An inverted curve is a signal that investors believe the Fed’s current rate-raising efforts are going beyond what the economy can handle and overnight rates will eventually fall.” Mr. Lahart further explains what’s blinding the Fed to such signals, “The Fed believes longer-term rates are lower than they should be because of all the bonds purchased by the Fed, central bankers around the globe in an effort to prop up their own countries. That’s driven term premia to zero.” In a corollary, author Lahart uses the 2006 Fed view of the inverted yield curve was the product of their assumption about a global savings glut and how it has pushed down long-term interest rates. Although this perspective may have been correct, the Fed missed the dynamic of how low interest rates drove investors to take on more risk to boost yields they couldn’t achieve any other way – pushing investment activities out on the risk continuum. This equated to a Fed blind spot that many market watchers claim still holds true today.
Whether an inverted yield curve indicates an imminent recession or not, a number of macro analysts have recently provided a significant amount of opinion and insight as to what’s causing the curve to invert. Here are some of the markets more compelling arguments:
Inflation Expectations
Vanguard’s economist Joe Davis describes the reliance of the yield curve as an indicator, ”Although it’s not infallible, the yield curve is the single most important indicator of an impending recession.” The part of the curve he focuses on for such feedback is the 3 month/10 year spread, since the 3-month rate really reflects sentiment on cash and cash equivalents and the 10 year is very reflective of future economic consensus. Davis states, “Obviously, we all know why short-term interest rates are rising, but what’s less certain is why longer-term rates are remaining so low.” Davis relates these low rates to inflation expectation and that America just fundamentally don’t believe inflation is going to accelerate. However, at some time this must change. He cites the most power force in finance is mean reversion. But he warns that the danger with mean reversion is what mean are we reverting to? In other words, is a low inflation low rate environment the new normal?
The venerable Burton Malkiel stated in a July 2018 Wall Street Journal article, “In general, inverted yield curves have always accompanied restrictive market conditions initiated to reduce inflationary excesses and to moderate economic activity. However, most market watchers agree that today is different. Instead of attempting to corral run-away inflation the Fed is simply trying to normalize rates in preparation for the next downturn.” In other words, slowly build up interest rates to a point that a significant enough reduction could be made to counteract the next recession. Furthermore, Malkiel makes the case that investors today should not be as worried about an inverted yield curve because of very low rates at an unusual time in the global financial markets. The current global environment he refers to includes other central banks, such as the ECB and the BOJ, that have monetary policies the opposite of the U.S. “Long term rates in Europe and Japan are very near zero, or below, making the current yield on long-term Treasuries look very attractive, especially in light of an increasingly more valuable dollar. In addition, foreign investors have always preferred U.S. Treasuries over other sovereign bonds outside of yield. Thus, low U.S. Treasury yields may signal something different today than in the past.” That something different is the idea put forth that short-term Treasury yields are impacted by Fed policy and long-term rates are impacted by bond investors. Thus, opposite ends of the curve are being pushed in opposite directions for reasons unrelated to the general economy.
In a July 2018 Wall Street Journal article entitled Fed Officials Debate Signal from Flattening Yield Curve: Is This Time Different? Atlanta Fed President Raphael Bostic is quoted, “The 2’s/10’s spread has narrowed to levels not seen since 2007, or 0.3%. Any inversion of any sort is a surefire sign of a recession.” However, in the same article Federal Reserve Chairman Jerome Powell was quoted, “I don’t see a flatter curve as a warning of recession. An inverted yield curve has preceded recessions in part because inflation was allowed to get out of control, and the Fed had to tighten, putting the economy into recession. That’s not the situation we’re in now.” Janet Yellen and Jerome Powell seem to be signing from the same sheet of music. They both have expressed their view that an inverted yield curve isn’t a huge worry because its probably a reflection of investors inflation expectations rather than growth expectations. And at the long end of the curve, yields are so low because of the rest of the world’s central banks continuing to practice QE, making rates in the U.S. more favorable.
Conversely, the Federal Reserve Bank of St. Louis research shows that the flattening of the real (nominal less inflation) yield curve may simply reflect the fact that real consumption growth is not expected to accelerate or decelerate from the present growth rate of about 1% year over year. This concept relates to the asset-pricing theory, which says the real interest rate measures the rate at which consumption is expected to grow over a given horizon. In other words, a high 1-year real interest rate signals high expected consumption over a 1-year horizon, and the same for 10-year real rates. If the difference between the two yields is positive (positive yield curve) then growth is expected to accelerate, and vice-versa.
Spectrum of Issues
CIO of Alhambra Investments and prolific writer Jeffrey Snider has recently stated, “Economists don’t understand bond markets because they don’t do money. Central bankers have not come to grips with yield curves and we keep paying the price. Decoding yield curves is essential to framing actual conditions and therefore the start of any rational analysis.”
Snider claims economists and central bankers think of the curve as a single line – the 10-year yield is a series of 10, 1-year forwards stacked on each other – the more academic case. With this philosophy in mind Snider claims the Fed believes it can influence rates in years 2-10 by causing rates on the first 1-year forward to increase – which it does by setting it’s policy rate, or Fed Funds rate. However, this academic perception is all wrong according to Snider. Instead, Snider claims that a yield curve is a spectrum of issues competing with and against each other. The yield curve, in Snider’s description, is a mechanism for setting probabilities about two very complex arrangements: the interaction between short and long-term rates.
Snider explains, “In the real-world banks and money dealers, who focus on the short-end of the yield curve, pay attention to money alternatives such as fed funds rate, collateralized repo rates, short-term treasuries, and ABS commercial paper. At the long-end of the yield curve banks and other investors invest in economic opportunity, but keeping in mind the risk associated with time value. The interaction between the long and short-end is not always direct and immediate. The long-end can interpret the conditions of the short-end independent of mainstream convention. The short-end of the curve is highly influenced by the Fed’s monetary policy while the long-end clarifies those policies through the prism of risk and return. A steep curve suggests accommodative policy likely to work over time. Flat or inverted curves suggest the opposite, where investors in the long-end are highly suspect of the current policy in light of current conditions.” Snider highlights the mid 2000’s as evidence of his views when Greenspan kept raising rates at the short-end by the 10- year Treasury rate didn’t budge. Snider’s explanation was bondholders didn’t agree with Greenspan’s rosy economic outlook.
Monetary Deceleration & World Dollar Liquidity
In Hoisington Investment Management’s Quarterly Review and Outlook for 2018, fourth quarter, author Dr., Lacy Hunt outlines the causes of the flattening yield curve. Dr. Hunt refers to the fact the fourth quarter of 2018 marked the second anniversary of a major deceleration in money and bank credit aggregates. Those aggregates peaked in October 2016 and has been on an irregular decline since. Money supply growth was the 4th lowest quantile since 1990, and we’re in the middle of further deceleration. Currently the six-month rate of growth is under 3% and the one-year rate of growth is under 4%. Historically, money growth is about 6.75% since 1900. The consequence of this decline has been a flattening of U.S. Treasury yield curve and a retrenchment in world dollar liquidity. He goes on to add the Fed’s nine policy rate increases since December 2015 as another influence in the flattening yield curve from the.
Dr. Hunt describes the current monetary environment as QT3, or the third round of quantitative tightening. He notes that excess reserves dropped from a peak of $2.7 Trillion in August 2014 to a recent level of $1.5 Trillion, and likely to fall to $0.9 Trillion by YE18. Dr. Hunt uses two equations to demonstrate the level of effect QT policies have had:
M2 = MB x m. The background for the meaning of this equation can be stated as the Fed can neither print money not reverse the printing press. What it can do is raise or lower the monetary base, or MB. But there is no certainty that there will be a corresponding change in the money supply (M2) or bank credit unless the money multiplier, m cooperates. The Fed’s balance sheet and “m” are of equal importance. Thus, MB is not money, only potential money. The multiplier is what converts MB into money, but this isn’t likely to happen because of the flat yield curve (an unfriendly environment for the banks to lend) and over-indebtedness. Currently, MB is declining and “m” is countervailing to a small degree. The drop in the monetary base and an increase in Fed funds rate has resulted in a sharp slowdown of M2 growth rate from a peak of 7.5% per annum in October 2016 to slightly more than 4% by YE18. According to Dr. Hunt M2 is likely to move even lower.
WDL = MB + Foreign Holding of U.S. Treasuries. Dr. Hunt says, “this equation for world dollar liquidity (WDL) shows the Fed’s de facto position as the world’s central bank. WDL declines when the monetary base falls unless its offset by an increase in foreign official holdings of U.S. Treasuries – which is not happening. On ongoing reduction in WDL forces a de-leveraging.”
Dr. Hunt’s views lead him to conclude that recent restrictive monetary conditions signal that a change in Fed policy is in the making. Given the above circumstances, even a mild recession would necessitate significant rate cuts, which will be difficult as they are truncated by the zero bound. Further, a slight recession would lead to such diminished inflation that the U.S. economy could face zero inflation or deflation. In certain sectors debt levels would become onerous enough to eventually turn a slowdown into a more persistent and/or deeper funk.
The Fed faces the difficult task of working with both price (interest rates) and quantity (money supply) to influence economic activity. Present circumstances reveal very low money growth, tighter bank liquidity, and the inability of several sectors of the economy to borrow due to higher rates. All point to a continuing economic deterioration.
Dr. Hunt also makes the point that data now show recent Fed actions have spread through the financial sector and into the broader economy. Dr. Hunt’s data includes waning inflation and the decline in interest sensitive industries like auto’s and housing. A fall in inflation doesn’t normally happen until the economy is already in recession, which was not the case in 2018. This suggests that final demand is weaker than other indicators imply. As 2018 ended, several high-multiplier sectors appear to have either passed their cyclical peaks or rapidly approached them, including exports, auto’s, homes, capital equipment and oil and gas drilling. All of these sectors exhibited characteristics of sectors in recession.
Going forward the U.S. economy will face past and continuing restraint of monetary actions. First, the flatter yield curve means that financial entities that borrow short and lend long will find their activities less profitable and will slow activity or increase risk premiums making credit more expensive or less available. Second, world dollar liquidity continues to decline. Third, the velocity of money fell during the fourth quarter of 2018, possibly indicating a re-start of its multi-year downtrend. Fourth, monetary restraint will tighten financial conditions.
In selected previous recessions the Fed Funds rate decreased by 300 basis points and the inflation rate fell 1.3%. But previously they both fell from higher beginning rates. Current lower rates and inflation circumstances are due to lower velocity of money, higher debt and poor demographics. Therefore, a larger decline in inflation and rates can be expected. This environment could force the Fed to engage in another untested experiment with unforeseen consequences to boost debt levels. In other words, we could have zero short rates for years.
Savings Glut & Funding Holiday
According to author and macro historian Russell Napier, “much of the downward pressure on the long-end of the curve has been in the works for decades and due, in large part, the U.S. dollar acting as the world’s reserve currency. Post 1998 the world witnessed the most rapid rise in foreign reserves ever seen. World foreign reserves peaked at $10 Trillion which flowed into various country’s bond markets. The capital flows into the U.S. structurally depressed the U.S. Treasury yield curve. As a result of currency interventions by the more largely developed economies, with the intent to devalue their own currencies versus the U.S. dollar, these buyers of U.S. Treasuries were effectively forced buyers. They were forced since such currency intervention generated huge trade surpluses that had to be parked somewhere after they were generated.”
Napier as well as most macro analysts agree that the U.S. Treasury system is the world’s safe haven investment and the preferred parking spot for foreign central bank reserves. Napier states, “A forced buyer is not a smart buyer, which was evidenced by the continued buying of U.S. Treasuries even as yields continually declined.” However, Napier posits the question, “Are foreign reserves actually savings or are they dollars created out of central bank manipulation and is there a distinction to be drawn?” He answers his own question by claiming foreign reserves are not savings, but instead dollars created through central bank actions. The point of making this distinction is to shine the light on a little understood perspective. This dollar creation by foreign central banks gave savers a “funding holiday” from the funding of the U.S. governments balance sheet, freeing them up to invest in a wide variety of other positions, including stocks.
Now this dynamic is coming home to roost. Napier states, “Five years ago, foreign central banks accounted for 1/3 of all U.S. Treasury ownership and today it’s less than ¼. In addition, between the expected issuance of new issues this year and the expected disposition of Treasuries by the Fed, the increment of new Treasuries on offer this year as a percentage of GDP is to be the highest since 1945. In other words, the supply demand balance has shifted. Today $1.3 Trillion of new U.S. Treasury issuance must be purchased by savers, while the current growth rate in savings is about $900 Billion. In 2014 roughly $250 Billion of U.S. Treasuries were purchased by savers. This obvious dislocation was on display last December as the stock market experienced its worst performance since the Great Depression. The sharp decline in stock market indices were a function of a reallocation of savings from equities to U.S. Treasuries by global savings. The bottom line is that global central banks no longer fund the U.S. government.”
Napier poses a second question, “What does this dynamic do to yields on U.S. Treasuries? It should drive them higher, right? But due to a concept called reflexivity this isn’t happening.” The term reflexivity in financial circles was made famous by Billionaire investor George Soros as described in his book The Alchemy of Risk. Reflexivity refers to the effect of changing prices begets a further change in price. Because such change in price changes our beliefs and expectations and thus behavior on where prices are going. Refelxivity is perhaps one of the best examples of how all investing has a strong amount of behavioral issues. As Napier says, “U.S. Treasury security is the most reflexive asset in the world.”
Similar to Lacy Hunt, Napier also describes the interaction of the monetary base and the money multiplier, and how the muted money multiplier has failed to convert increased monetary base into actual money and rising inflation expectations. “Monetary policy over the past 10 years has created only narrow money, no broad money since banks aren’t lending. This is occurring partially because Baby Boomer want to repay debts. The final baby boomer turns 50 on 12-31-18. The simple rule of retirement is retire your debt or don’t retire. Baby Boomers are dominant customers of banks, and money is created by banks extending credit and thus creating deposits. If the biggest pool of customers is de-leveraging it will be difficult for monetary policy to generate enough money to create the inflation we need to inflate away our debt.”
This demographic situation could be why monetary policy isn’t as powerful as it used to be. Quantitative Easing is the oil in the machine but not the accelerator as Irving Fisher declared. If you don’t create money as you de-lever you cause what happened in the U.S. from 1929 to 1932. Recent Quantitative Easing has succeeded in helping the U.S. private sector smoothly de-leverage, but it hasn’t forced anybody to re-leverage, and thus hasn’t created more growth.” All of these factors are powerful influences on keeping rates at the long-end of the curve very low.
Fear the Steepener
Well-known macro analyst Charlie McElligot from Nomura Securities makes the basic argument of not fearing the yield curve inverting, but the opposite, fear its steepening post inversion. McElligot explains, “when the yield curve steepens the general capital markets will have sniffed out the economic slowdown that’s been caused by recent policy tightening, known in the U.S. as interest rate normalization.” McElligot cites the significantly slowing housing and manufacturing industries as well as the “deflationary impulses we’re seeing around the globe right now.”
According to McElligot the slowdown is yet to be understood since monetary policy has a lagging effect that can take up to as much as two years for it to be observed. “When it is observed”, McElligot contends, “the lagging impact of tightening will start to lead into financing and funding and ultimately the costs of capital. There will be a multiplier in that such higher cost of capital will cause behavioral shifts from corporate management regarding a pullback of capex investment, further reducing economic performance.” For McElligot this economic slowdown speaks loudly to the imminent Fed easing cycle in the not too distant future.
McElligot’s confirmation of an impending Fed easing cycle is the current Eurodollar curve conditions. The Eurodollar curve is a way to trade short-term interest rates because it acts as a proxy for U.S. Treasury rate futures. McElligot states, “As the Eurodollar curve inverts, looking forward 1 or 2 years, the market is beginning to believe that somewhere in that time frame the Fed will stop hiking and move to slight easing. The Eurodollar curve inversion is a signal telling us we are transitioning to risk-off positioning. The 2/6’s spread (the second contract and the sixth contract) is now inverted. The Eurodollar curve speaks to the very front-und of the U.S. Treasury curve, and it shows, over the past five easing cycles, the Eurodollar 2/6’s spread has inverted prior to each. More specifically, on average, 6.5 months before a Fed cut.”
Reflexivity
Similar to investor Stanley Druckenmiller, who claims the era of free money eliminated the discipline of an investment hurdle rate, Peter Cecchini of Cantor Fitzgerald believes the effects of QE have distorted investor expectations of what the permanent cost of capital is. “Monetary policy has become a form of price fixing of the cost of capital. Historically monetary policy was open market operations on the short-end. It has morphed into longer term and the type of rates involved. More control over the price of money. Capital allocators today are thinking in terms of lower hurdle rates.”
Fed Governor Lael Brainard recently confirmed this view saying, “the Fed has not been able to affect interest rates and inflation, but it’s actions on the market have affected the market itself. Price fixing is starting to have the opposite effect of unintended disinflation.”
Cecchini recounts recent financial history, “In late 2016 the shape of the yield curve was influenced by the narrative around the presidential election. The narrative at that point was focused on how we were going to get a steeper curve given the pro-growth policies Trump was bringing to the White House. This narrative definitely took hold with the 2’s/10’s spread widening to 235 basis points. As time passed markets began to understand Trump was not going to have an easy time with his growth agenda through both houses, while, concurrently, we had super-low rates around the globe – specifically in Germany and Japan. The influence of these events was to flatten the curve significantly, setting the stage for what we have today with the ECB controlling the long-end of sovereign yield curves around the globe using extraordinary amounts of monetary policy easing. At the short-end, the Fed has raised rates nine times to a range of 2.25% to 2.5%. The flat U.S. yield curve is not a recession indicator today. The reflexivity argument says you need to act on the long-end of the curve because you don’t have enough growth. Clearly, market participants are most mindful of that fact today. “
Did the Fed Miss its Opportunity?
Renown author and macro analyst James Rickards recently stated, “the Fed always follows the business cycle except for now. Now is different due the need for normalization as a way of adding tools to the tool box for the next recession. However, this new agenda is causing them to try to raise rates into the face of a weakening global economy.” Normalization in this context is letting its bonds held on its balance sheet mature – no rollover. Rickards says, “As the balance sheet is reduced so is the money supply. This reduction in money supply has had a significant tightening effect on monetary policy, nearly equivalent to the Fed’s hiking of rates.”
Rickards claims that the Fed missed their window in 2010-11 as the proper time to raise rates when the global economy was trending up. Since then they’ve been playing catch-up. Rickards states, “History shows that it takes 300 to 400 basis points in rate cuts to pull an economy out of a recession. The Fed’s balance sheet went from $800 billion to $4.3 trillion during the Great Financial Crisis, along with interest rates falling to zero. Today, the Fed is trying to get ready for the next recession by elevating rates high enough above zero as to have enough room to cut rates again to zero in the next recession. Similarly, the Fed is trying to roll off enough of its assets on its balance sheet to be able to add it back.”
Rickards goes on to call out the challenges the Fed faces going forward, “The Fed is in the midst of a dilemma. It believes that it needs to hike rates to 3.0% to 3.25% and simultaneously reduce the balance sheet to $2.0 to $2.5 trillion to provide enough room to cut future rate and increase the future balance sheet to help pull the economy out of the nest recession – what many are already referring to as QE4. However, it’s very likely the U.S. economy will experience its next recession before the Fed reaches either of their milestones. The Fed’s dovish pivot in January is a strong example of that. The dilemma is how does the Fed tighten money to the degree of their milestones without the act of tightening itself sending the economy into recession?” Most market watchers don’t think it’s possible.
Financial commentator and radio personality Peter Schiff has a slightly different take on the Fed missing its window. In a recent speech he gave to Cambridge House Mr. Schiff claims “It’s not the future rate hikes that will push the U.S. economy into recession, it’s the past rate hikes that will. The Fed’s moves since 2015 have guaranteed a recession. The mistake was not raising rates, in fact rates should have been hiked by more and earlier. The mistake was cutting rates to zero and then holding them there forever. The same mistake Greenspan made earlier.”
Schiff make the ominous prediction that given our extraordinary high level of debt QE4 will have to be many times larger than QE1,2,and 3 combined. And although the Fed will try it won’t be able to save the market next time. And when the market sees that the Fed has no power left the market crashes and we’re back to NIRP and ZIRP, along with a growing Fed balance sheet in perpetuity. The result of all this for Schiff is that “the Republicans lose the presidency in 2020 and the next president is a socialist Democrat who will likely give us much higher taxes and regulation to fund their laundry list of social programs. Since the U.S. is already broke, such profligate spending will cause the dollar to plunge and likely causing its reserve currency status. The only way out will be a U.S. government default on the debt and entitlements.” Schiff concludes his warning, “The fact the Fed had to abort rate normalization at 2.25% should tell you the Fed can’t ever get rate normalization done, and it’s the beginning of the end.”
With regards to the upcoming challenges the Fed faces, Schiff takes a very similar view as Rickards, “In 2018 we had an 11% increase in global debt to $247 Trillion, or three times global GDP. Plus all the malinvestment made because of low rates. How do we regularize interest rates today? If you don’t normalize interest rates the debt problem gets bigger. If we do normalize rates we’re going to have a problem by slowing the economy into a potential recession – and it will be bigger today because we didn’t normalize four or five years ago. The seeds were born in 2003 when we had 9% growth, low rates and serious malinvestment for three to four years. We tried to solve the problem of too much debt with more debt.”
Conclusions
Whether you believe it happens next month, year, or decade a recession in the U.S. will happen. Do the recently inverted U.S. Treasury yield curve and the inverted Eurodollar curve indicate that a recession is imminent? It seems from the above market consensus that history is on the side of saying yes, but then again that same sentiment seems to be saying, this time it’s different.
