On some days, especially during the summer lull, the absurdity inherent in the endeavor we call economics is almost too much to bear.
Because markets are the playground of “economic man” (and woman), they too come across as farcical when observed dispassionately, from afar.
Policymakers tried so hard to forestall a ruinous deflationary spiral in 2020 that they ended up with a ruinous inflationary spiral two years later, the solution for which, we’re told, is the deliberate engineering of a new deflationary spiral, only milder. If all goes according to plan, rates will be high enough by this time next year for policymakers to start cutting them again, if necessary to avert a deflationary overshoot. If an overshoot happens anyway, and inflation plummets amid collapsing demand and a resolution to various supply side distortions, policymakers will then embark on a reflationary quest.
It’s ludicrous. It’s also funny. And mostly impossible to get right, even under benign conditions and subdued macro volatility. Current conditions are anything but benign and macro volatility is on the rise. In all likelihood, policymakers are condemned to a slapstick routine defined by wild oscillations and overshoots. Sometimes, policy will chase market pricing, other times market pricing will chase policy. Everyone will chase their own tails together. And each other’s tails too.
It’s with all of that in mind that the US 2s10s curve inverted for the third time in as many months Tuesday (figure below), a testament to the notion that even the “wisest” of markets is short circuiting — a robot doused in water, like the hair-trigger algos that trade it.
If that’s a recession signal, we now “owe” the bond market three downturns.
“The commitment of the global central banking community to follow-through on promised rate hikes contributes to the ‘different this time’ theme of the current cycle [and] beyond the embedded ‘third inversion’s the charm’ narrative, the fundamental backing for duration to outperform at this stage in the cycle is particularly strong,” BMO’s Ian Lyngen and Ben Jeffery wrote, adding that “Powell introduced a recession into the public discourse and conceded that it’s worth the risk to preserve the Fed’s hard-won credibility as an effective inflation fighter.”
Note that the RBA delivered a second straight 50bps hike on Tuesday (figure below). If Philip Lowe was out of patience last month, he’s downright antsy now.
July’s RBA meeting marked the first time in history that the bank has hiked 50bps consecutively.
You’re reminded that until very recently, Lowe clung desperately to the notion that no rate hikes were forthcoming until 2024. He’s now hiked 125bps in three meetings. “The resilience of the economy and higher inflation mean that extraordinary support is no longer needed,” he said Tuesday.
The idea is that it’s now or never. With the exception of the UK, developed market economies are, by and large, still a semblance of resilient, and can thus “handle” aggressive front-loading to curb inflation. As BMO’s Lyngen put it, “the presence of lingering positive economic momentum at the moment provides urgency for monetary policymakers to normalize rates while the opportunity remains.”
That brings us full circle, and rather quickly as my articles go. This dynamic — whereby rate hikes are seen as an effort to free up countercyclical “breathing room” — isn’t new. It’s policymakers’ modus operandi. You tighten so you can ease later. But in addition to being absurd, it’s also a trap. With each go-around, the economy seems to lose something in the way of capacity to handle higher rates. So, each tightening cycle (in the US anyway) undershoots the scope of the preceding easing cycle, with the effect of ever easier policy on net, over time. That’s been the case in the US since the mid-80s.
There’s a natural limit to that dynamic. Eventually (and theoretically), the economy and markets will lose all capacity to tolerate tighter policy such that even a single rate hike could be “too much.” That prospect would be disconcerting enough on its own, without inflation forcing the issue.
Everything is faster this cycle. The recession and bear market were faster, as was the recovery and attendant bull market. It now seems just as likely as not that the Fed’s hiking cycle will be extremely truncated too. As of Tuesday, markets — from rates to crude, which tumbled 10% below $100/bbl — were virtually screaming recession. If things continue along this trajectory and the Fed follows through with another 75bps at July’s policy meeting, that might be it. Markets and the economy might not be able to cope with additional tightening.
If that turns out to be the case, it’ll effectively be game over. Where do central banks go if markets and the economy simply refuse to countenance the amount of policy tightening necessary to rein in inflation?
Theoretically, that’s impossible. A market collapse and demand destruction triggered by overzealous tightening should bring inflation down posthaste. But this is a different kind of inflation. And if the last two years taught us anything, it should be that “theory” isn’t a very good guide. Especially when it comes to inflation.
The real question left unasked is if the markets are tightening financial conditions more than the FOMC (example mortgage rates up 250-300), why go 75 now? If the Fed goes 75 and has to do an about face shortly after how is that good for credibility? Far better to do a smaller hike and then make it stick or at least not have to do an about face immediately thereafter. Maybe then do another smaller hike if you need to – or not. The street and pundits crowing about credibility have none themselves in my view. Anyway a really strong dollar coupled with falling energy and commodity prices does not suggest the Fed is losing on inflation anymore. As Keynes once said, I change my mind when the facts change, and you sir? (paraphrase).
While off their peaks, wheat is still up33% Y/Y and gasoline over 60% Y/Y. I don’t think that is a strong indication of abating inflation, at least not yet.
Bread is still the cheapest part of my sandwich, and I still have to drive to work (assuming I remain employed). Rates will have to go up a lot more if the metric is gas and wheat prices. A housing market lockup will limit the fed’s ability to raise rates long before they touch inflation imo
Less than 75 will not leave them enough credibility to squander later. Even with 75 real rates are way below 0. Only the heavily invested with exuberant profits over the last 2 yrs “suffer”.
100% agree with this view, market has tightened financial conditions more than what Fed has delivered actual tightening, so in that sense forward guidance has been effective. Given recent data I think your suggestion that the Fed should act more rationally by hiking less than 75bps and “letting that sit” makes a lot of sense, which sadly means the Fed won’t follow that path.
The nasdaq rallying today says it all
Given the markets screaming recession now, what will they do if the Fed delivers the indicated 75 bps rate increase this month? Personally I won’t be surprised to see a knee-jerk reaction downward.
It seems like the Fed has to deliver 75 bps because they’ve all said Inflation is the biggest threat to economic stability. I suspect today’s rally will reverse as multiple Fed speeches this week reinforce that they don’t have inflation beaten (and don’t dare stop lest mass psychology of inflation further entrenches). Yes it’s messy but that’s the predicament when they were slow to start.
This Inflation is global (somewhat undercutting “the US fiscal relief caused it” – oil is an input into almost everything much like no-longer-shutdown China manufactures for everyone), and as almost every central bank tightens they almost start compete with each other for actually receiving savings; countries (and companies) dependent on debt are going to have a miserable Q3 and onward.
Look at a long term chart of CPI YOY% (inflation) with recession bands. Every recession has seen inflation get cut in half or more. There are no exceptions, not even in the inflationary 1970s and 1980s.
Sometimes inflation rolled over as soon as the recession started, other times it didn’t roll until late in the recession, but it always rolled and fell by at least half.
Is it going to be “different this time”?
Todays inflation is from commodities (food, energy), housing, supply chain, and wages. Commodity prices are rolling over, oil has been the last to crack, other commodities are already in major pullbacks. House prices will decline even if rents continue rising, and OER is bigger in the CPI basket than actual rent. Supply chain is improving, e.g. container prices, inventories, semiconductors. Wages may (hopefully will) remain upwardly pressured at the low end, but the higher end is probably slowing (tech definitely is – more about that later).
There is also Putin and Xi. Putin may keep NG/LNG prices high but, at least in the US, NG is a very minor part of the basket. Xi could damage the supply chain with more lockdowns, but those have deflationary effects (commodities) as well as inflationary.
All in all, I do not see a compelling case for this being the first and only recession since WW2 that fails to choke out inflation.
Now, that doesn’t say whether inflation will come surging back after the 2022/23 recession, as happened after the 1970 and 1974 recessions. Things are different today (the 70s were a pretty high growth period, GDP growth exceeded 5-6% in the recoveries) but also not so different (energy supply was tight throughout the 70s, and I think that could be the case throughout the 2020s). So maybe we’ll get to watch That ‘70s Show over the next decade – that’s not my base case, but its hard to rule it out.
Whatever happens, as H said, everything is indeed happening faster in this cycle. The recession (whether a “real” one or a “technical” one) is coming faster than most thought, I think inflation is likely to start rolling over faster than most thought – the market seems to be pulling that expectation forward as we watch – and the Fed’s easing response to recession may come faster than most think.
I’ve been holding lots of cash, accumulating dry powder for the market bottom, looking for the chance to do 2020 all over again (though with expected returns much lower/slower). I’ve been sort of mentally penciling in late 3Q22 / early 4Q22 as the time period when cash will get put to work. For various reasons (we can discuss later), that seems plausible to me.
But I am worried. I’m worried that things will happen earlier, and I’ll be caught flat-footed. If they happen later, that’s okay. I am worried that my summer vacation plans will slip away. Darnit, I really want to go fishing.
About wages – anecdotally, from a friend at a early growth phase tech company that does software for SMB, in the last month the tech job market has flipped.
His company was struggling to hire staff to keep up with growth, and seeing their new hires poached away after just a few months with big raises, the tech job market was super-hot. Now they can pick their candidates, the ones who jumped ship are being laid off and trying to get their old jobs back, offers are being withdrawn all over the industry.
However, their clients – small and medium biz in the Old Economy, think contractors, accountants, restaurants, and so on, typically 100 or fewer employees – are (still) struggling to hire enough people, he is seeing no slowdown there.
Finally, about why pencil in late 3Q / early 4Q?
– Fed will deliver the next 125-150 bp of hikes (FOMC members have been too explicit about it to do otherwise), which will take until at least Sept (75 in July, no Aug, 50 in Sept?)
– Fed won’t consider easing up until have seen “repeated” cooling inflation prints, not “nuanced” ones, which will require at least 3-4 months (just two isn’t enough)
– The other thing that could force the Fed to start easing up, which is unemployment jumping by over 100 bp, is not going to happen in the next few months (just my opinion, but data like JOLTS and claims would practically have to do sudden 90 degree turns)
– If the next 500-700 pts on SP500 need to come from earnings cuts, feels like we’ll need two earnings seasons to get there (I don’t see NTM estimates getting cut -15% in just one quarter, especially not 2Q when companies and analysts can still pretend)
So all that makes me think the bottom doesn’t get put in before the penciled-in period.
It could just be wishful thinking. Talking my own vacation plans, as it were.
Call me short-sighted but I still can’t understand why the Fed isn’t using balance sheet unwinding instead of some of the rate hikes. Too slow? Frankly, I like the rate hikes because bonds will get profitable sooner.
The first $2.1T of Fed balance sheet unwind will likely be mostly offset by a reduction in the ON RRP ($2.1T as of July 6, per FRED)- as banks decide to purchase treasuries ( instead of borrowing Treasuries) to meet liquidity requirements.
So no real tightening impact. I think, until Fed gets the ON RRP balance back to zero- where it “normally” resides.