So on October 3, the Federal Reserve chairman said we were “a long way from neutral.”
And indeed we are.
On Wednesday, the junky monkeys who populate the stock market thought they heard something different. They thought that he turned dovish and that his tone changed. Well, they are wrong. And while the Dow and the S&P 500 did indeed enjoy their second-best session of the year, if the Fed truly has turned to a more dovish stance, wouldn’t that be reflected in the one security that is the most sensitive to shifts in monetary policy? I’m talking about the two-year T-note yield, of course, which fell the grand total of 2 basis points yesterday to 2.8%. Big deal. Yields out the Treasury curve barely reacted at all. As usual, the “bondies” have the story right. The equity market does not, but who ever said that it doesn’t respond to hope every now and again?
He didn’t say the Fed is close to neutral. He was more specific — he actually said, for the record, that “interest rates are still low by historical standards, and they remain just below the broad range of estimates of the level that would be neutral for the economy — that is, neither speeding up nor slowing down growth.”
This time around, he didn’t say rates were well below neutral; he said rates were slightly below the low end of the range of estimates. That range is estimated to be between 2.5% and 3.5% — so at a 2% to 2.25% band right now, rates are between 25 and 50 basis points below that low end. And rates are still about 75 or 100 basis points shy of the midpoint, which is what Powell was referring to back on October 3.
So you see, nothing has really changed.
Figuring out the neutral rate
Some people say that the neutral funds rate is next to impossible to estimate, but I’m not so sure that’s the case.
Going back 30, 40, 50, or 60 years even, you will see that the Fed funds rate, on average, lies about 100 basis points below the prevailing trend in nominal gross domestic product. Right now that trend is 5.5%, but that is clearly being skewed by the transitory influence of the fiscal stimulus. For 2019, nominal GDP is likely to average 4%, in my view, and so that would place the neutral funds rate on this basis at 3% — smack dab in the middle of the Fed’s estimated band. The Fed actually is closer to 4.5% as a base case for nominal GDP growth, so, by that standard, one can argue that the high end of the range for neutral may be more appropriate. Though one can be forgiven for the typical stock market bull wanting to believe that as soon as we get to the bottom end of the 2.5%-to-3.5% funds rate band, we can then take the Fed off the worry list … as if.
Interestingly, what Jay Powell said on October 3 that really got President Donald Trump riled up was the comment that the Fed was probably going to have to go above neutral. That was the comment that drew the ire. And somehow yesterday, I didn’t see the Fed chairman walk that one back. And history shows that the Fed has never, not once, completed a tightening cycle without taking the funds rate above neutral. Even during the “soft landing” episodes in the mid-1960s, mid-’80s and mid-’90s. Don’t ever bet against history rhyming.
And I hardly detected any sounds of worry in his voice. He seems pretty bulled up. He said he was “forecasting continued solid growth.” So why pause? In terms of the financial sector, he says “the system is now much stronger.” So why pause? He says “financial institutions and markets are substantially more resilient than they were before the crisis.” So why pause? He adds that “household debt would not present a systemic stability threat if the economy sours.” So why pause? He didn’t mention any concern about the general softness and heightened volatility in stocks — he only said “equity market prices are broadly consistent with historical benchmarks such as forward price-to-earnings ratios.” So why pause? He specifically said “it is important to distinguish between market volatility and events that threaten financial stability.”
You see — he isn’t worried about weakness in equities barring some systemic risks being generated. He mentioned that “large, sustained declines in equity prices can put downward pressure on spending and confidence.” So he will react to such a situation, but so far we haven’t really seen anything “large” or “sustained” for that matter. So why would he pause?
If it’s a pause in Fed policy that the bulls are hoping for, they may want to rethink the thesis because recessions start, on average, after the central bank stops tightening policy. Caveat emptor.
The stock market’s extreme response was telling
Something else to consider is how the stock market responded to what Powell had to say on Wednesday. He really hardly spun the dial — nuance at best. But the market’s extreme response is symptomatic of despair. Grasping at straws. It conjures up the image of how the equity market rallied hard at the peak of the cycle over a decade ago, only to keep rolling over.
August 17, 2007 — The Fed announced a cut to its discount rate (50-basis-point cut to 5.75%). The Fed also released a statement saying: “The Committee is monitoring the situation and is prepared to act as needed to mitigate the adverse effects on the economy arising from the disruptions in financial markets.”
The Dow was up 1.8% (233 points) that day. With 20/20 hindsight, it was a rally to fade.
September 18, 2007 — The Fed cut the funds rate by 50 basis points to 4.75%. The Dow was up 2.5% (336 points) on the move. Who knew the peak was just a few weeks away?
December 21, 2007 — The Fed embarked on the first acronym to bolster market liquidity, the TAF (biweekly Term Auction Facility auctions), “for as long as necessary to address elevated pressures in short-term funding markets.” The Dow jumped 1.6% (205 points). A bounce to sell into.
January 23, 2008 — The Fed cut both the funds rate and the discount rate by 75 basis points. The Dow jumped 2.5% (299 points).
January 31, 2008 — The Fed again cut the funds rate and discount rate by 50 basis points apiece. What do you know; the Dow rallied 1.7% (207 points). Another head fake.
March 11, 2008 — The Fed unleashed a new acronym: the Term Securities Lending Facility (TSLF). “The Federal Reserve will lend up to $200 billion of Treasury securities to primary dealers secured for a term of 28 days.” The Dow soared 3.6% (416 points) on the day, and I remember it well. The bulls declared the worst to be over. So what if they were a year early?
March 18, 2008 — The Fed cut rates by 75 basis points to 2.25%; it also cut the discount rate from 3.25% to 2.5%, and the Dow went on to spike 3.5% (420 points).
April 1, 2008 — The Fed announced its approval of the Bear Sterns takeover by JPMorgan. The Dow jumped 3.2% (391 points).
So what’s the point of this exercise? It’s this, and I could easily have done the same thing for 2001 and 2002 as well. After long bull markets and economic expansions, it is not constructive when the Fed stops tightening and switches to easing. The market’s preoccupation with the Fed is not at a healthy development any more than it was back then.
We are nearing the peak
And don’t forget the most important thing that Jay Powell said on Wednesday:
“We also know that the economic effects of our gradual rate increases are uncertain and may take a year or more to be fully realized.”
The lags! This is key because with the contraction of the balance sheet, the Fed has already de facto tightened the equivalent of over 300 basis points this cycle. That’s more than it did in 1994 when only Netscape going public the following year and ushering in the internet mania prevented the economy from slipping into recession. Even if the Fed pauses after the December hike, the $600 billion of quantitative tightening in 2019 will be the same as if Powell et al. raise rates 130 basis points.
In all likelihood, the aggregate tightening by the Fed this cycle will approach 550 basis points. No expansion ever survived that degree of policy restraint. And with the 2s/5s yield curve within 3 basis points of inverting, the bond market is starting to sniff out the recession, which could well begin next year. At some point, the Fed will play a role in helping put in the bottom, but seeing as we are nearing the peak of the expansion and credit cycle, all bets are off that there is anything the Fed can do to prevent the downturn from taking hold.
Recessions are inevitable facts of life, because humans run the Fed and as smart as they are, they make mistakes. And pause or not, the mistake was already made … first by Bernanke in 2013 by getting scared away from the “taper tantrum” and then by Yellen in 2016 as she backed off because of the emerging-market turmoil and Brexit. So just as Burns and Miller handed the baton to Volcker who had to clean up their mess, now Powell has had to do the dirty work that Ben and Janet should have done ages ago. Another cycle of staying too loose for too long and then the Fed having to overtighten, which it may have already done. Given the inherent lags, we will know for sure a year from now.
Powell had a clear warning
As for the excesses out there, Powell was pretty direct — the corporate balance sheet:
“There are reasons for concern, however. Information on individual firms reveals that, over the past year, firms with high leverage and interest burdens have been increasing their debt loads the most. In addition, other measures of underwriting quality have deteriorated, and leverage multiples have moved up. Some of these highly leveraged borrowers would surely face distress if the economy turned down, leading investors to take higher-than-expected losses — developments that could exacerbate the downturn. The question for financial stability is whether elevated business bankruptcies and outsized losses would risk undermining the ability of the financial system to perform its critical functions on behalf of households and businesses.”
“Looking across the landscape of major asset classes, we see some classes for which valuations seem high relative to history. For example, even after standard adjustments for economic conditions, valuations on riskier forms of corporate debt and commercial properties are in the upper ends of their post-crisis distributions, although they are short of the levels they hit in the pre-crisis credit boom.”
Forewarned is forearmed. We have a $6 trillion investment-grade corporate bond market with half of the outstanding amount rated BBB, or on the cusp of being downgraded to junk. Almost 30% of the companies in this huge BBB tranche have debt-to-EBITDA ratios in line with the average in the noninvestmemt credit arena. The only way we avoid a wave of ‘fallen angels’ this cycle (BBBs that get pushed into “junk”), which would create an intense tightening in financial conditions with knock-on effects across all risk asset classes, is for the corporates in question to repair their balance sheets. Especially at a time when super-tight labor markets will be absorbing a greater share of cash flows, meeting the rise in debt-service costs will compete heavily with capital spending, share buybacks, and dividend payouts.
There is no “get out of jail free” card to play. Next year’s focus will be on debt servicing and debt retirement, and likely at the expense of shareholders. Either that or we see a raft of credit downgrades that force corporate bond spreads wider, with the increased debt cost of capital impairing economic growth and the rerating in spreads triggering a compression in P/E multiples given their time-worn correlation.
Heading into 2018, the title of our outlook was (with regards to the Chinese zodiac) The Year of the Dog (will it bark or bite?). As we move into 2019, I think it apropos to update it to The Year of the Pig (lipstick won’t help!).
David Rosenberg is a chief economist and strategist at Gluskin Sheff, the previous chief North America economist at Merrill Lynch, and the author of the daily economic report “Breakfast with Dave.” Follow him on Twitter @EconguyRosie.