Albert Edwards: ‘There’s Too Much Linear Thinking Out There!’

It won’t surprise you to learn that SocGen’s Albert Edwards isn’t particularly optimistic about the Fed’s capacity to normalize policy without collapsing various Jenga towers on the way to a dovish about-face that’ll be every bit as embarrassing as it was inevitable.

“For all the Fed’s newfound bravado and bluster, we know by now that any attempt to ‘normalize’ interest rates will end in elephantine pivots, pirouettes and ignominy,” he wrote, in a note dated Thursday.

Edwards touched on a number of topics discussed here at length over the past several weeks, not least of which is the idea that the Fed’s eagerness to slay the inflation dragon is almost surely motivated in part by Joe Biden’s sagging approval ratings and, ultimately, concerns about what persistent inflation might presage for the 2024 presidential election.

Read more: A Recession To Save Democracy?

Edwards called the first week of 2022 “a lively start to the year.” Indeed. US reals notched their largest weekly surge since the turbulent days of March 2020 (figure below).

He went on to attribute the Fed’s “tardy rediscovery of its inflation fighting zeal” to Biden’s “slumping popularity in the polls, as voters suffer from the current cost of living squeeze.”

As noted on Wednesday (see the linked post above), Biden’s approval rating took its biggest hit from the Afghanistan withdrawal, but what we don’t know is whether that dip would’ve proved fleeting had inflation moderated and Build Back Better advanced.

Whether you believe the social spending bill would be fuel on the fire vis-à-vis inflation is irrelevant for this particular discussion. The point is that when something goes awry with the economy, the last thing you need is for a senator from your own party to torpedo your economic agenda. In the public’s eyes, that suggests something must’ve been wrong with the legislation, even if, as survey after survey showed, most voters didn’t know much, if anything, about the provisions included in Build Back Better.

In any event, “Rip Van Fed has finally woken up and decided it’s time to stop the fun,” as Edwards put it.

Unfortunately, “stopping the fun” almost always entails triggering some manner of financial “event,” something BofA’s Michael Hartnett is keen to point out whenever the opportunity presents itself which, in 2022, is likely to be at least once per week.

As the familiar figure (above) illustrates, Fed tightening cycles end in tears. It’s just a matter of who’s crying and where.

If you wanted to posit a simple explanation for why the market is skeptical about the Fed’s lofty longer run ambitions for the policy rate, that’s a good place to start. Of course, there are a number of more nuanced explanations, but if cocktail parties are ever allowed again, the terminal rate won’t be any better of a conversation starter than it was prior to the pandemic.

Edwards on Thursday used a chart from Gerard Minack (below) which would be self-explanatory even without the colorful annotations.

“The markets don’t really believe the Fed can ‘normalize’ rates anywhere close back to the 2.5% the Fed themselves postulate is ‘neutral”” Albert wrote.

He went on to toss out a few additional questions, warnings and anecdotes. For example, he suggested that the — let’s call it peculiar — nature of the current recession and subsequent recovery might just mean history isn’t a good guide when it comes to timing the onset of the next downturn.

“After the shortest recession on record… there might be too much anchoring by investors on the concept of long, resilient economic cycles,” he said, before suggesting “this cycle may yet prove to be unusually fragile to the lightest of Fed touches.”

Further, he flagged the disconnect between credit spreads and the EPU index. I’ve highlighted such disconnects between measures of political angst and market-implied uncertainty in the past. Edwards went on to use another chart from Minack (below) which shows that (and I’m quoting Albert’s summary), “although we are not at the single-digit lows we saw just ahead of the last recession, we are still well below normal.”

Finally, Albert mentioned a conversation he had recently with a colleague conveniently named “Jerome.”

Jerome’s been reading a lot lately, and as it turns out, there’s quite a bit to worry about, including new, deadlier pandemics, a water crisis, “the unfolding collapse in gulf stream currents and its dire consequences on food production,” political decay and societal breakdown.

From all of the above, Edwards came to one key conclusion. “After everything we have experienced since 2008, any portfolio manager should probably contemplate allocating a non-zero share to catastrophic hedging,” he wrote, before exclaiming, “There is simply too much linear thinking out there!”

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