Way back in May of 2018 (and likely before that), SocGen’s Solomon Tadesse warned that the Fed would only be able to squeeze in a total of three more hikes.
The argument was straightforward. Measuring from the lows in the shadow rate, the amount of Fed tightening already delivered by the summer of 2018 exceeded that seen during previous cycles.
“Accounting for the impacts of QE on what would have been the Fed rate absent the zero-bound, we argued that the course of the current tightening was much closer to its top by historical standards, projecting about three rounds of rate increases to reach the peak by December 2018”, Tadesse wrote, in January of last year, once it became apparent that the Fed was destined to cut rates after being blamed (rightly or wrongly) for the Q4 2018 selloff.
Tadesse proceeded to recap the math. Taking the effective Fed rate at the time (about 2.5%) and adding the 300bp rise in the shadow rate from mid-2014 (mirroring the wind down of QE) the total amount of delivered tightening stood at about 5.5%.
Here’s a visual representation of how things looked at the time (i.e., around 15 months ago):
(SocGen)
Needless to say, things have changed quite a bit since then. The Fed began cutting rates last summer amid pressure from Donald Trump, whose trade war with China was weighing heavily on global growth expectations. Then, September’s funding squeeze necessitated an “early” resumption to monthly asset purchases on the heels of the Fed’s decision to cease balance sheet runoff. Then came COVID-19.
The rest, as they say, is history. We’re back to zero and the balance sheet has ballooned by some $2 trillion in a matter of weeks. Had you shown someone the following chart at the beginning of 2019, they would have been incredulous.
While there’s no disputing that the coronavirus pandemic is the proximate cause of the unfolding global recession (the worst since the 1930s) and also the catalyst for the extraordinary barrage of easing witnessed in March, many observers have gingerly suggested that the die was cast well before COVID-19 emerged from a wet market in Wuhan and began to spread among the locals.
After all, the curve had inverted at multiple points and on several occasions. As I will never tire of reminding readers, global growth and trade came into 2020 on the back foot, having just trudged through 2019 at the most sluggish pace in a decade.
What you’ll note from the chart is that peak policy tightening came in 2018. 2019 represented what, at the time, seemed like quite the concerted global easing push, although it pales in comparison to what we’ve witnessed over the past 45 days.
With that in mind, consider that in a new note, SocGen’s Tadesse revisits his message from 2018 and 2019 and underscores the notion that, pandemic or no pandemic, the cycle was probably going to turn.
“The ongoing pandemic has turned life upside down, triggering, among others, the worst economic and market meltdowns in recent memory”, he writes, noting that “with the depth of the crisis and corresponding unprecedented policy actions, it might be tempting to ascribe the market woes exclusively to the onset of the” health crisis.
That wouldn’t be entirely accurate, he contends. And here’s why:
External shocks of epic magnitude have afflicted human lives in the past, but their occurrence often intertwines with the natural course of economic cycles, obscuring our understanding of cause and effects in the process. To be sure, there have always been shocking triggers behind major economic crises. Yet, while the specific triggers and internal dynamics vary from cycle to cycle, the broad profiles of every economic downturn and the associated ramifications to asset prices have remained the same throughout history. It can be argued that, as grave the consequences are, the pandemic may have triggered a natural next phase of an ailing economy, albeit disproportionately amplified, on the course of its normal economic cycle.
To back up that contention, he cites the discussion outlined here at the outset, noting that the beginnings of a pro-cyclical rotation in Q4 notwithstanding, the US was decelerating in 2019 and “signs of fatigue” in markets were “there for all to see”.
Those signs of fatigue include the above-mentioned measure of total policy tightening and, of course, the yield curve. Here’s one additional short excerpt from Tadesse:
Yield curve inversions correctly signaled upcoming recessions in all post-war economic downturns. The US curve inverted multiple times before this downturn as well. Our own favorite signal measures the degree of monetary policy tightening and correctly predicted peak tightening to be reached in December 2018. A tightening peak indicates an overheating economy, ushering in an upcoming economic slowdown with potential recessions. Indeed, a study of monetary policy cycles shows that peak tightening has preceded every recession during the last 60 years.
To drive the point home, he updates the chart from the left pane in the first set of visuals above. In short, the Fed hit the ceiling at around 5.5% of de facto tightening (i.e., when you account for the unwind of QE).
(SocGen)
So, if your question was whether the longest US expansion in history was on track to end even without the onset of the worst public health crisis in modern history, there’s a strong argument to be made that the answer is yes.
Of course, there’s a certain sense in which suggesting that seems somehow untoward and there are more than a few folks out there who will argue this is one recession the yield curve can’t claim to have “called”.
But, at the end of the day, cycles always turn. If they didn’t, they wouldn’t be “cycles”, now would they?
YEP…………………