On Friday, we learned that consumer sentiment in the US fell sharply in August from July and that the deterioration was in large part due to the first Fed rate cut since the crisis.
“The main takeaway for consumers from the first cut in interest rates in a decade was to increase apprehensions about a possible recession”, Richard Curtin, director of the University of Michigan consumer survey, said. “Consumers concluded, following the Fed’s lead, that they may need to adopt a precautionary spending outlook in anticipation of a potential recession”.
That’s an extremely ironic state of affairs. The whole point of the “insurance” cut was to instill confidence that the Fed is sufficiently cognizant of the extent to which the uncertainty engendered by the trade war has the potential to undercut the US economy, just as it has economies abroad.
Trump, though, has figured out that short of engineering a controversial shakeup in the Fed’s leadership, the best way to get the rate cuts he thinks he needs to make the US economy “take off like a rocket ship” (to employ the president’s vernacular) is to be an agent of chaos – to create so much uncertainty that the Fed has no choice but to embark on a full-on easing cycle.
The president is helped along in this by the bond market. The trade war is taking a heavy toll on the global economy and that’s manifesting itself in rate cuts from global central banks and expectations for additional policy easing. Between deteriorating growth outcomes, the assumption of more easing and collapsing inflation expectations, bond yields have plummeted around the world. Term premia spillover and the effect of negative yields on investor psychology in other locales has helped turbocharge the bond rally stateside, and it’s gotten an extra boost from receiving flows/hedging dynamics. The more lopsided positioning gets, both in terms of the duration infatuation and outright bets on Fed cuts at the front-end, the more perilous an exercise is disappointing those expectations.
The market, then, becomes Trump’s accomplice in cornering the Fed. There is a very real risk that disappointing market expectations for three more cuts by the end of the year will serve to tighten financial conditions, thereby making those cuts necessary anyway, raising uncomfortable questions about whether policy is now so market-driven that outcomes are preordained.
In the final act, the relentless pressure on the long-end against the Fed’s characterization of the July cut as a “mid-cycle adjustment” has led to unwanted flattening, which in turn makes the Fed appear woefully behind the curve, ostensibly making rate cuts even more critical to take some of the pressure off, not only in terms of the curve, but also in funding markets.
“Unlike his predecessors, [the] current president seems like a significant consumer of convexity. His statements and actions often contain implicit embedded optionality”, Deutsche Bank’s Aleksandar Kocic writes, in a new note.
That creates what Kocic calls a “real nonlinearity” in the monetary policy-politics nexus, which is now defined by “an implicit moral hazard associated with running a massive long convexity position”. That position, Kocic notes, “is like being overinsured [and] the problem associated with such a position is that it is not profitable”. Simply put, if there’s not a calamity, that position loses value over time.
But, someone who’s overinsured can cash in – by engineering a catastrophe.
“This means that such a position fosters an escalation of risk taking [like] having an overinsured car compels one to drive less carefully [or] accumulating large amounts of debt beyond the ability to repay makes default more compelling”, Kocic goes on to write.
That raises an obvious question. “Who will underwrite the political demand for convexity (and at what price)?”, Kocic asks.
The answer, of course, is the Fed, but doing so makes Jerome Powell an enabler. His characterization of the July cut as a “mid-cycle adjustment” suggests the central bank is still pushing back against its exaptation into the political process, but Deutsche’s Kocic warns that “the longer the current tensions persist, the less resistance the Fed is likely to show [as] in the absence of coordination between politics and monetary policy, the convexity imbalance is likely to continue to support short dated volatility further”.
If Powell doesn’t act soon and act aggressively, he runs the risk of seeing the economy talk itself into a recession. We saw evidence of this in the August consumer sentiment data.
One problem is that the more extreme pricing gets in the bond market, the more difficult it is for the Fed to deliver a “dovish surprise”. That, in turn, raises the odds that each successive rate cut will be ineffective at reducing the pressure in funding markets and in the curve, until eventually, we hit the zero lower bound having accomplished very little along the way.
“This is another dimension of uncertainty that could keep vol from further decline”, Kocic goes on to write. “By resisting to cut rates quickly and decisively, the Fed is risking the actual recession in the US [but] if they give in to the market or political pressures, they might run out of bullets if the economy in the US encounters a bump”.
The Fed needs an excuse to justify the kind of U-turn that would satisfy markets, but the data most assuredly isn’t giving them much. Retail sales just logged a fifth consecutive monthly gain, the second quarter GDP report painted a picture of a healthy consumer, we’ve seen two straight months of hotter-than-expected core CPI readings, wages are firming and manufacturing gauges appear to be rebounding (besides MNI’s noisy Chicago barometer, which looks awful).
In addition to extreme action in bond markets, one other “data point” that might compel an Draghi-esque “whatever it takes” moment is, of course, another steep equity market rout. There’s more than a little irony in that – if Trump wants the kind of monetary largesse that he insists would underwrite the equity market and all but rule out a deceleration in the economy, he might need to see equities slide first. (Like Thanos sacrificing Gamora to get the Soul Stone.)
And yet, there simply isn’t enough time for this to play out prior to the 2020 election, something Kocic hints at.
“Despite inflated praise, when put in the context of previous presidencies, the S&P rise since Nov-2016 has been at best mediocre”, he writes, adding that “another double digit decline… would be practically disqualifying”.
What’s the answer? Well, Kocic suggests that given the desire to avoid becoming one of the worst stock market presidents in recent memory, the US administration “might be compelled to double down on current strategies, either through additional political pressures on the Fed or explore the alternatives like currency channels”.
So, higher volatility it is then, one supposes.