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Higher tariffs reduce future economic growth expectations and increase general uncertainty (e.g., what if tariff wars escalate further? what if China stumbles and brings down the rest of the world with it?). If the Fed fails to offset the increased demand for money this creates, then deflationary forces will take root and the risk of a recession (though still very low in my estimation) will increase.
Chart #1
Chart #2
In Chart #1 we see the significant decline in both nominal and real yields that has occurred since their November '18 peak. 5-yr Treasury yields have fallen over 100 bps, from 3.1% to 1.96%. 5-yr TIPS real yields have fallen by 80 bps, from 1.16% to 0.36%. Inflation expectations are down to 1.6%, but that could be largely due to the recent decline in oil prices, as shown in Chart #2.
Chart #3
Chart #3 compares the current real Fed funds rate (blue line: the difference between the Fed's target funds rate and the year over year change in the PCE Core inflation rate) with the market's expectation of what that real rate will average over the next 5 years (red line: the real yield on 5-yr TIPS). The message here is that the front end of the real yield curve is inverted, and that is a sure sign that monetary policy as it stands today is a bit too tight. Whereas the Fed says it is likely to stand pat for the foreseeable future, the market is saying they need to cut the funds rate target to 2% (vs the current 2.5%), and hold it there for the foreseeable future. The last two recessions were preceded by a similar inversion of the real yield curve (i.e., the blue line exceeding the red line), but the one important difference between now and the last two recessions is that real rates were much higher then than they are now. Red lights are flashing today, but this is not a four-alarm fire; it's more like the need for some modest adjustment to policy.
Chart #4
Chart #4 is the best chart to illustrate the impact of monetary policy on the economy. It combines the real Fed funds rate (blue line: the true "cost" of borrowing money) with the slope of the Treasury yield curve (red line: the difference between 1- and 10-yr Treasury yields). When the yield curve is flat or inverted and real interest rates are high, a recession has always followed. Today the yield curve is flat, but real interest rates are still relatively low. The current situation is problematic, but a recession is not imminent or foreordained.
Chart #5
Chart #5 is the classic way to look at the shape of the nominal Treasury yield curve, as measured by the difference between 2- and 10-yr Treasury yields. Here we see that the nominal curve is still somewhat positively-sloped. Again, a recession is not foreordained nor imminent. The market is sending a strong message to the Fed, and the market is betting that the Fed will respond accordingly.
Chart #6
If the Fed were really, really "tight," we would be seeing swap spreads rise, which would be an indication that liquidity conditions were deteriorating. Instead, we see swap spreads falling (see Chart #6). I interpret this to mean that the market is buying swap spreads in addition to Treasuries (pushing both yields down), in an attempt to hedge against the risks posed by Trump's tariff wars. We saw the same action in late 2015, when real GDP growth fell almost to zero. (That was also the time when oil prices collapsed from $100/bbl to $30/bbl, creating shock waves throughout the oil industry that threatened to spread to the rest of the economy.) The Fed is not really "tight" today, since they are not trying to restrict liquidity; they are simply keeping short rates a bit too high. The fundamentals of the economy are still sound, but the market is worried and so the market is paying up for bond-market hedges like swaps and bonds.
Chart #7
Chart #7 tells the same story. Credit Default Swap spreads have moved up a bit, but they are still relatively low. The market is only marginally concerned about the outlook for corporate profits. We're talking about a slowdown in growth, not a recession.
Chart #8
Chart #8 shows the market's expectation for what the Fed's target funds rate will be by the end of this year (as derived from Fed funds futures). From its high point of 2.93% last November (which implied two tightenings), the market now sees the funds rate target falling to 2% (which implies two easings). If the Fed doesn't get this message and act on it soon, then we might expect problems.
Chart #9
Finally, Chart #9 shows how the equity market is dealing with these issues. Fears (as measured by implied equity option volatility, or the Vix index) are up and growth expectations (as measured by the 10-yr Treasury yield) are down, which adds up to a moderate spike in the Vix/10-yr ratio. Equity prices have responded by falling, as they have during past "worry" episodes. The current episode is not yet of the significant variety, however. The Fed still has some time to react, but they shouldn't delay too long.
40 comments:
Got to love this post. Monetary policy driven by the price of your Apple stock.
No Fred, monetary policy driven by the price of the 10 year note which is trading sub 2.15%. Did you not read the post?
steve: thank you
Read his posts over the past 10 years and you will see he is inconsistent on monetary policy and has advocated for rate cuts recently whenever the market tanks because he knows it will rise again if the Fed cuts. He argued there was no deflation at the bottom of the financial crisis. Check out Brian Wesbury for more consistent analysis on rate cuts
Anyone who advocates for NO rate cuts here is simply ignoring the markets-at their peril. I am NOT saying the Fed WILL cut as their track record is pretty darn dismal. I would not advocate for fed cut for investment but rather economic reasons.
Moreover, your statement that the market (stocks) rises whenever the Fed cuts rates is laughably incorrect. Def not a guarantee that stocks rise when Fed cuts.
https://awealthofcommonsense.com/2018/12/a-history-of-fed-rate-hikes/
Stocks are tanking because of Trump's irresponsible trade policy. If he stops with the tariffs then the market will recover. Market was on a tear when it thought we had a deal with China.
Fred, I think you're largely correct as to why stocks are swooning but that does not address the core reason as to why the 10 year is trading at 2.13%. If Fed changed rates based on stock performance we'd be all over the place. When stocks bottomed on 12/24 the ten year was trading at 2.75%. Since then stocks have rallied 17%. Something is AMOK and it's more than just DT's trade nonsense.
I'm amused that anyone would think "The Market" was alive and could talk !
More important: Is "The Market" a male, female, or some other gender?
Exactly who is doing all that talking ?
The people buying stocks/bonds, or the similar number of people selling stocks/bonds to them ?
Why is "The Market" not interviewed on the evening news?
Does "The Market" ever want interest rates to go up ?
I sold my stocks and MFs in mid-May. The Administration has the power to rile markets. I don't trust key members of it not to go short and knock the hell out of everything.
snp500 divi yield is more attractive than tbills, 2650-2700 snp frwd pe still at 16 area....
sell in may took a long time to come back around....the auto sector was softening before any tariffs came into play, it was key driver of leading out of G recession..140 million cars since cash for clunkers....might be time to get out of auto sector....especially with EV
Great post.
My two cents is that I agree with Scott Grannis and also believe the Fed should halt its reverse QE program (the reverse QE program may have been a bad idea from the very beginning).
The threat to the economy from Trump's trade tariffs is mostly in the headlines of the financial media. The size of the tariffs in relation to the size of the US economy... Well, the math just isn't there. There is a threat that investors will pull in their horns having read headlines in the financial media.
I happen to disagree with Trump's 5% tariff on Mexican imports. But the Mexican peso could have appreciated by 5% for some other reason, and that would have about the same effect on the US economy... but with no headlines, no market response.
Let us hope the globalists and the Fed decide not to "teach Trump a lesson" and bring about a global recession.
Side note: the most powerful commercial enterprises of all time are today's multinationals, and they have formed alliances with the Communist Party of China, the most powerful political party of all time.
President Trump does not choose his adversaries wisely.
So who will prevail? The elected President of the United States or the global combination of multinationals and Beijing?
hi scott - i think the current debate in the market is not whether the fed will cut rates but if rate cuts this time around will be enough to ignite another round of animal
spirits / drive cyclical outperformance in the market or we are pushing on a late cycle string at this point - curious if you have a view here? if you noticed today the dollar sold off on fed rhetoric and you saw a bid to cyclical sectors - feels like a lower dollar could have a material
positive impact but curious what you think - thanks
So the economy is the greatest of all time but we need a rate cut. Not a sign of resilience, it seems to me. I have a hard time believing the cost of borrowing is the problem holding the economy back. More likely it's related to lack of customers. Trump's silly behavior may be ncentive for global businesses to elsewhere for partners. It's about trust and stability. Not DJT's strong suit.
We have record unemployment, real wage growth recently, S&P up 40% in 5 years – and down just around 6% from all time high. Scott’s argument for a rate cut makes sense – especially related to demand for liquidity. Then, I’m not qualified to question otherwise. But echoing John’s comment, it’s frustrating that in a decent(?) economy we have demands for more monetary engineering. A few rate cuts – OK. But would it be good to see a few arguments that this economy should be able to stand on it’s own? Or we might be using up rate cuts we’ll need more critically in the future? Or some sense that debts actually do matter to those strongly arguing for MMT? Little concern for the deficit whether it’s individual tax cuts or promising massing infrastructure or social programs?
The answer to the economy’s general malaise must ultimately be policy changes – not monetary engineering, and definitely not trade wars or abdicating our role in promoting international order. Sometimes the debates get too lost in weeds and charts. Stepping back it should be easy to see, we need policies that promote more people having the freedom and incentives to produce – here and everywhere else in the world. Liberal social programs cause substantial harm in that regard. But Republicans ain’t no shining star either. Trump is an epic disaster – an epically bad trade for the temporary tax cuts or socially conservative judges we got out of him. Shaking my f.. head.
Randy is correct. The problem is the Democrats have no answers so we're probably stuck with Trump for another four years. Can you imagine how well the economy would be doing if we had a real business person running things?
Randy, I assume you meant we have record EMPLOYMENT NOT UNemployment. In any event, you're missing the point. The Fed should be responding to imbalances in interest rates regardless of perceived economic backdrop. The 10 year note is trading down in yield for a reason and the Fed cannot ignore such a drastic difference in market Vs Fed rates. It is for this kind of imbalance That Milton Friedman argued that the Fed should be governed by a computer-and that was 40 years ago!
Yes, I meant to say record LOW unemployment - thanks for correction. And I didn't credit enough the point - risk of inversion and access to capital dries up. I pretty much stick with the rest of it though!
Dude
I'm lost now, just a few weeks ago you said the economy was hitting all cylinders. Now, it seems that a rate cut is required because the economy is on the verge. It just goes to show that numbers can show whatever you want.
Huge sarcasm here.
I'm kind of frustrated that many of the readers do not understand the least about interest rates. When the 10 year note trades down from 2.75% to 2.1% and inverts WHILE stocks rally 15%+ AND the Fed leaves short alone-that suggests strongly the their is an imbalance and historically this has lead to recession. Will cutting rates .25% create more demand in the economy? Probably not. But given the latter AND given inflation is pretty damn nonexistent why risk a slowing future economy? It's all about interest rate BALANCE not about juicing the economy.
Chart #3 strongly suggests that 75 bps of cuts are needed (at least). Come to think of it, so does the FF futures market now (75 bps) by Dec.
I hope the Fed is sensitive to this. Some of the Fed chatter over the last few days suggests they kinda/sorta understand and are at least moving in the direction that respects markets more. Powell would seem to be one of the bright lights in this movement. On the other hand, some of the Keynesian talk, especially with respect to employment and inflation... My goodness. I mean, I'm sure Clarida is a nice man and he has a strong resume but...
Frozen: I have been careful to note for quite awhile now that the economy was neither booming nor on the verge of a bust. The data has been decidedly mixed, but the economy has managed to post 3% annual growth in the past two years, which is better than the prior 8 years, but nothing to celebrate wildly. And I have also been careful to note that the rationale for a rate cut has nothing to do with the economy being “on the verge.” Instead, I have made the point that the uncertainty surrounding the Trump tariffs, coupled with the market’s belief that the economy is slowing, have combined to create an increased demand for money. If the Fed doesn’t offset that with steps to boost the supply of money (by reducing rates), then the risk of deflation will rise and that could in turn lead to weaker growth.
"WASHINGTON (Reuters) - U.S. unit labor costs were weaker than initially thought in the first quarter and costs declined in the prior period, suggesting inflation could remain moderate for a while.
The Labor Department said on Thursday unit labor costs, the price of labor per single unit of output, dropped at a 1.6% annualized rate, instead of falling at a 0.9% as reported last month. Data for the fourth quarter was revised to show unit labor costs falling at a 0.4% rate in the October-December period, rather than increasing at a 2.5% pace as previously reported."
----30----
Gadzooks, there sure ain't any threat to inflation from wages. Unit labor costs have in reverse for six months, and hardly up in the last 10 years.
I hope there is a huge reassessment in the orthodox macroeconomics profession regarding wages. Anyways, it is past time not for more welfare, but for doing everything possible to keep labor markets tight and real wages rising for at least a couple generations. There are 150 million Americans in the employee class. I want them to buy into democracy and free markets. Rising real wages will do that.
https://fattailedandhappy.com/bond-market-smart/
One could be forgiven for thinking the Fed is trying to harm the working man. Seriously, every monetary metric indicates that the Fed is too tight. And yet, they seem to be achieving this moderate-but-chronic tightness just after the working man went through a forty year period of wage growth that failed to keep up with inflation. It's only been the last couple years where the blue-collar guy has seen an above-inflation growth in wages, and then only just. Oh no, we can't have that. Time to be too tight. Oy.
And none of the idiotic Dems ever raise this as an issue. When will they seize the (politically advantageous) idea that they could make hay with the middle of the country if they showed how the volatility that originates with the Fed hurts the working man? No, it's all about taxing, regulating, and expanding "free" everything.
Geez, I wish Jude Wanniski were alive to comment on this, and everything else.
From Brian Wesbury:
The Fed has no business cutting rates based on today's report on the labor market. Yes, nonfarm payrolls grew only 75,000 in May, well below consensus expectations. But that's not far below the roughly 100,000 per month pace needed to keep the unemployment rate steady and is well within the range of normal monthly variation. In the past year payrolls have risen an average of 196,000 per month despite months like February, when they only grew 56,000, or September, when they only grew 108,000. Civilian employment, and alternative measure of jobs that includes small-business start-ups increased 113,000 in May. A transition to a less rapid pace of job growth, consistent with low and steadier unemployment, need not mean a return to slower overall economic growth. Productivity growth, the growth in output per hour, has accelerated, growing 2.4% in the past year. Faster productivity growth is how businesses should sustain an expansion in a tight labor market. It's important to recognize that the details of the employment report were generally stronger than the tepid headline growth in payrolls. The unemployment remained at 3.6%, which is below where the Federal Reserve thought it would be at the end of 2019 (when they made their last public forecast in March). The U-6 measure of unemployment, which includes discouraged workers and those working part-time who say they want full-time jobs, fell to 7.1%, the lowest since 2000. Meanwhile, the median duration of unemployment fell to 9.1 weeks and the share of voluntary job leavers ("quitters") among the unemployed rose to 13.5%. Both of these are signs of a tight labor market. Average hourly earnings rose a moderate 0.2% in May, versus a consensus expected 0.3%. However, it's important note that average hourly earnings are up 3.1% from a year ago, an acceleration from the 2.9% gain the twelve months ending in May 2018. In addition, the total number of hours worked rose 0.1% in May and are up 1.5% in the past year. As a result, total wages are up 4.6% in the past year, signaling growing purchasing power among workers. We don't think the Fed should or will obsess about the miss on the headline payroll number for May and will not cut rates at the June meeting. In turn, our base case is that a combination of continued economic growth and improvement in trade negotiations with China and others will let the Fed off the hook, without cutting rates later this year.
Fred and Brian Wesbury: Maybe so, but I want Full Tilt Boogie Boom Times in Fat City and I want it to last for five straight years. I want record corporate profits and record low unemployment.
I want there to be such labor scarcity that even some of my family members get jobs.
I give up. Ignore the bond market at your own peril.
Best stock market week of the year. Interest rates down. Inflation muted. Economy strongest in a decade.
And Trump forces a deal to get more help from Mexico than Congress in stopping illegal immigrant flow from Central America.
Boom!
Record low unemployment for the most marginalized and poor people in American HISTORY.
Overall unemployment rate at 40 year lows.
There are more job openings than people looking for work.
Portfolios hitting FRESH new HIGHS yesterday. Bonds AND stocks screaming.
S&P Low Vol index up 18.4% YTD (even without dividend), trading at all time highs, and beating the S&P500 YTD by 400 bp.
Aggregate bond index total return up over 5% ytd!
Converts, HIGH yld, Senior Loans are up better than that.
TLT up almost 10% YTD, total return!
And this is all in just 6 months!!
Lordy, we may have to take a break, just to rest!
The Leftists and Deep State mafia STILL acting like spoiled children kicking on the floor after adults told them "no more ice cream", and "we are cleaning up your room now".
The Coup attempt backfired, spectacularly. Investigations against their illegal activities are ongoing.
Leftists and Deep State actors screaming like Vampires who have been exposed to light....and they have!
Maxine Waters chanting to literally dozens of supporters: In Peach 45!! In Peach 45!
More WINNING! Trump is The Boss with the Mexican deal. America First.
(How's it going in countries that are fighting against America??)
Trump might be right when he said we would win so much that we would get tired of winning!
But Im not tired of it yet. Still lots to make up for from the previous decade.
God Bless Donald!
Johnny Bee Dawg
The S&P 500 is EXACTLY the same as at the January 26, 2018 peak.
That was over 16 months ago !
Stop getting so excited !
Stop being a Trump cheerleader / lapdog !
Trump is a master BSer -- believe nothing of what he says -- believe only actual results.
Yes, I realize Trump has had an average Real GDP growth rate of +2.55% in his first two years, and that is better than under Obama, who averaged +2.2% after the December 2007 Recession ended in June 2009, but +2.55 versus +2.2% is not a HUGE difference !
My S&P Low Vol index is up 15.47% total return since Jan 26, 2018.
So I will just stay happy!
We just had the fastest GDP and Wage Growth in a decade.
Stupid regulations have evaporated. Lowest # regs & pages in the Federal Register in a QUARTER CENTURY!
Lowest unemployment EVER RECORDED for America's most marginalized citizens.
All accomplished during a coup attempt!
Imagine the deflationary collapse if Hillary had won.
God Bless Trump!
The Boss!
cliff, you're wasting your breathe. Arguing with a kool-aid Trumpster is the same as arguing with a crazy left wing socialist.
That trump actually believes that tariffs are "helping America" and profitable is proof of his idiocy and he surrounds himself with lickspittles. As I've said repeatedly, the alternative appears to be worse-at least on the left. Realistically, no Republican has a chance to gain he next nomination.
Really sad that in the greatest country in the world we have pitiful pols and candidates for POTUS.
steve is correct. It’s a waste of “breathe” arguing against Trump’s results!
Brilliant leveraging of US strength. Tariffs as a weapon. Let’s see how it goes.
Barack thought Trump had a “Magic Wand”.
“Those jobs are never coming back”
America is finally getting great again!
If the Fed stands ready to back Trump’s America First policy, we will gain concessions from foreign bad actors that were formerly thought unattainable.
To quote the great Lazlo Toth:
“Fight, Fight, Fight! Support Our President!”
If Trump’s negotiations succeed, he is setting us up for a generation of prosperity. Trade with an HONEST China could bloom into unimaginable benefits for both countries.
Bravo, Donald!
Response for Johnny B. Dawg:
"We just had the fastest GDP and Wage Growth in a decade."
My comment:
Better than Obama is not saying much ! Also, I stand by the Real GDP numbers and S&P 500 numbers in my prior comment.
"Stupid regulations have evaporated.
Lowest # regs & pages in the Federal Register
in a QUARTER CENTURY!"
My comment:
Best Trump accomplishment so far ... but ... the very important CO2 Endangerment Finding has not been challenged, so CO2 remains defined as a "pollutant', which is wrong based on science, and gives the EPA far too much power to disrupt our economy.
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"Lowest unemployment EVER RECORDED for America's most marginalized citizens"
My comment:
Not quite true. Data for black unemployment was first collected in 1972, but hispanic unemployment data were not collected until 2007 or 2008, which was during a recession, so claiming the lowest ever hispanic unemployment today is a meaningless claim. Asian data were first collected in 2000.
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"All accomplished during a coup attempt!"
My comment:
Agree, but the coup attempt is still in progress. We should be thankful the Obama Administration was so incompetent they could not disrupt the Trump campaign in 2016 -- they sure tried.
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I don't want anyone to think I'm a Trump basher -- I wrote a six page article on his first two years, and gave him a grade of "B" -- my primary complaints were too much spending, ObamaCare was still alive, and no new Mexico border wall construction.
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The trade war with China is not going well, as I have not yet heard China admit to a problem with theft of intellectual property. I have watched them making incredible upgrades to their military in the past decade, that just HAD TO be based on stolen secrets. Also: An "HONEST China" is an oxymoron.
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Concerning Mexico:
Mexico has made empty promises before about stopping / holding Central American migrants, yet April 2019 was a really big month for US border arrests. I'll trust Mexico when I see actual results. If they put troops on their southern border to stop Central Americans from coming in, will that mean fewer Mexican troops will be available for fighting the Mexican drug gangs (the incoming drugs hurt the US much more than incoming illegal immigrants do -- Mexican drug gangs participate in both crimes) ?
Mexican authorities can't control their drug gangs. Those gangs make money by sending drugs into the US, and taking Central American people into the US. If the Mexican authorities can't stop drugs from coming into Mexico (most fentanyl comes from China), then why should we expect Mexican authorities to be able to stop Central Americans from coming in to Mexico, and being taken to the US border by the drug gangs? This sounds like wishful thinking until actual results, from a few months in a row, prove it is not.
I think looking at the US is the wrong approach. I am not sure the US is de-coupled any longer. We are just following the rest of the world with a lag. Today >50% of global GDP is from EM and China, the engine (~30% of global growth/50% of credit creation), is showing no real signs of life. More worrying is that all of the highly linked economies (Brazil, Europe, Korea) seem to be getting worse rather than better. I am sympathetic to the argument that it will take time for their recent stimulus to flow through, but something has to turn around very quickly. Chinese PMI leads global PMI by about 9 months which means at a minimum we probably have to see weak growth elsewhere through the end of the year.
Again, I think the US will following the rest of the world with a lag. However, for the last 3 years it's been insulated due to a sentiment boost (mostly partisan), tax cuts, a wealth effect, and large scale QE/chinese stimulus in 2016. Now that the sugar high is wearing off things are slowing quickly and the overall global picture is worse than 2016 (just look at a global PMI heatmap. It's a sea of red). With that said, if global growth rolls over in a synchronized, I am not sure how the US will keep chugging along. We may appreciate the cheaper gas and lower rates but I don't think that's going to be enough to re-ignite things. Curious to hear your thoughts about US resilience in the face of increasingly weak global growth.
America is great again, the naysayers keep nagging....they worry about inverted yield curves that have happened many times before in the history of America, were still here...
Doom is a great sell, easy to have a bunch of lemmings to jump all over it....
Democrats are the worst economists in the world. They continually flail to understand that right now, the one shining star is America, money is pouring in from all over the world.
China tariffs are a nothingburger, lets see what they do with a billion screaming citizens....
they cave before summer is over...
Tariffs are starting to legitimately bite. I'm getting e-mails from small businesses explaining the soon to be increased prices to us consumers.
Explicit costs starting, implicit costs of supply chain disruption TBD.
I'm curious to see how long before we have a real and sustained corporate profit rollover precipitating a real bear market in stocks.
Dow Jones Industrial Average has best start to June since 1940!!
GDP upward revisions coming.
Record number of job openings (1.6 million!!) exceeding those looking for work.
Record low unemployment for our most marginalized citizens.
Multiple investigations underway for abuse of government power by coup attempt participants.
Massive, unprecedented crackdown on illegal immigration underway!
Rule of Law finally being respected by government again.
Regulations slashed.
Government “advisory boards” being slashed by 1/3!
America is Becoming Great Again!!
God Bless Donald!!
I listened a pretty interesting interview with Leon Cooperman https://www.cnbc.com/2019/06/20/leon-cooperman-big-move-higher-for-stocks-could-be-close-out-move.html
You can see below a short summary and an investment suggestion from him based on his fundamentals. I haven't understand all of his conclusions and likely not correctly captured them, so feel free to comment.
We are in abnormal time today. Despite a) stimulative fiscal policy, b)very strong retail sale, c) very low interest rate, which is already incorporate inflation - USA economy is growing only 2%. It only could be explained with 12+ trillions of sovereign debts.
What is normal today according to Cooperman. a) Productivity growth is about 1.5% + labor force growth 0.5% determine real growth about 2%. b) with 2% real growth+ 2% inflation the nominal growth is 4%. With 4% nominal growth the interest rate suppose to be 3% and not 2%. The interest eventually in 2-3 years will trend toward of 4% because of a global interest rate.
With 4% nominal interest rate the market suppose to have the multiple 17(Note: I think the calculation is the stock yield 1/17 =6% is bigger than 4% risk free interest), which with SP500 earning of $170 corresponds to SP500 about 2850. I.e with today's level SP500 of 2950 the market is fairly valued. With giving 10%-15% overvalued range Cooperman suggest to reduce the stock exposure after SP500 will be over 3100 level. The jump of the stock to this level is closing one according to him.
La economia austriaca tendría que difundirse mucho mas entre los comentaristas y sobre todo los banqueros
No hay q repetir errores pasados y soñar en un 'gran ilusión'
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