Confusing Times And The ‘Incomprehensibly Incompatible’

It’s a confusing time to be alive.

In general, I mean. But also in the more narrow context of the economy and capital markets, where it’s increasingly unclear whether the most basic concepts still apply.

Last week, Morgan Stanley’s Andrew Sheets attempted to square the circle by artfully presenting cycles as a kind of paradox. Most “normal” cycles are in fact unusual, he said. But their peculiarities notwithstanding, cycles exhibit patterns, many of which were readily observable just prior to the pandemic and in the months since. For Morgan, the current cycle is likely to be hotter, shorter and more compressed thanks to policy support, but it’ll still be “normal,” according to the bank.

Read more: ‘Normal’ Is A ‘Funny Concept,’ One Bank Reminds You

Sheets did briefly recap what he called the “self-explanatory” debate over cycle normalcy. “The case for viewing this situation as unique, and distinct from other cyclical experiences, is based on the view that a fall and rise this violent never allowed for a traditional ‘reset’,” he wrote, a week ago.

A few days later, the NBER said the pandemic recession lasted just two months. It’s entirely reasonable, albeit extremely callous, to ask whether that even counts. Callous because it certainly counts for the millions of lives destroyed by the pandemic. But, as SocGen’s equity derivatives strategists wrote late last week, “the extremely short nature of last year’s recession combined with very rare combined easing of monetary and fiscal policy does raise questions about whether this really is a new cycle or if the team of Fed/US federal government/Congress has just managed to prolong the previous cycle by offsetting the negative impact of last year’s sudden economic stop.”

In “When ‘As Good As It Gets’ Ain’t All That Good,” I highlighted a visual showing revisions to the CBO’s output gap estimate. As SocGen’s Jitesh Kumar noted, “if you remove the data points around the time of the pandemic, the output gap chart does indeed suggest we could be in an extension of the old cycle.” The modified figure (below) is an illustration.

The potential problem here should be obvious. Seen through this lens, the current stance of US monetary policy is nothing short of ludicrous. To be clear, I’m not suggesting this is the proper lens through which to view the situation and it’s not SocGen’s base case either. But it’s an interesting thought experiment.

“Broadly speaking, central banks try to fine-tune their monetary policy stance to align it [with] the business cycle,” Kumar went on to write, before noting that “in the current economic context, however, the expected business cycle stance next year (a strongly positive output gap) is likely to be incomprehensibly incompatible with the easiest-ever monetary-policy stance, $120 billion of monthly QE purchases, $2.5 trillion of excess household savings, and $4.5 trillion in money market-fund assets.”

That’s a great quote irrespective of whether you find this analysis compelling. The figure (below) underscores the point.

Given that, you should be able to write the rest of the story (poem) yourself. I should emphasize (one more time) that this is not SocGen’s base case, but Kumar wrote that if this scenario were to play out in 2022, the Fed “may be forced to hike rates very quickly in the second half” quite possibly triggering “a sharp move in financial conditions [and] a spike in volatility.”

Worse, that hypothetical would play out at the end of the cycle, opening the door to a situation where the Fed hikes into a falling economy. Markets wouldn’t likely be amused with that decidedly unfavorable juxtaposition.