Fed Will Lean On Its Primary Tool

Still on vacation, probably about to leave cell service, so quickly today…

Federal Reserve Chair Jerome Policy delivered his widely-anticipated speech at the Fed’s annual Jackson Hole conference and left intact expectations that the Fed would ease at the upcoming September FOMC meeting. Importantly, Powell acknowledged that the Fed was in uncharted waters here:

We have much experience in addressing typical macroeconomic developments under this framework. But fitting trade policy uncertainty into this framework is a new challenge. Setting trade policy is the business of Congress and the Administration, not that of the Fed. Our assignment is to use monetary policy to foster our statutory goals. In principle, anything that affects the outlook for employment and inflation could also affect the appropriate stance of monetary policy, and that could include uncertainty about trade policy. There are, however, no recent precedents to guide any policy response to the current situation. Moreover, while monetary policy is a powerful tool that works to support consumer spending, business investment, and public confidence, it cannot provide a settled rulebook for international trade. We can, however, try to look through what may be passing events, focus on how trade developments are affecting the outlook, and adjust policy to promote our objectives.

There is little precedent for what currently faces the economy. Typically, fiscal policy makers only need to be slapped down once by the markets before they abandon obvious policy mistakes. Think how market participants reacted to the initial failure of TARP to make its way out of Congress. President Trump, however, repeatedly doubles-down on bad policy, leading the nation into a full blown trade war with China. Moreover, it doesn’t look like this is ending anytime soon. China retaliated last Friday, Trump retaliated again and then, after first seeming to express second thoughts, directed aides to say the second thoughts were only about the magnitude of the retaliation. He thought he should have done more.

The policy uncertainty, which includes ordering U.S. firms to stop doing business with China and calling Powell an enemy of the people, will most likely continue to weigh on investor and business confidence.

Realistically, the Fed has only one primary tool in the near term with which to respond to the ongoing uncertainty and its negative impacts on financial markets directly and the economy in general: Rate cuts. There is no other path forward here; if the economy is in a good place as the Fed believes, and the risks both real and hypothesized are primarily on the downside, the Fed will cut rates until they have stabilized the situation.

How many rate cuts will that require? Of course we don’t know. What we do know is that market participants know that one is not enough. And Powell knows that keeping financial conditions accommodative is partly about meeting financial market expectations:

Committee participants have generally reacted to these developments and the risks they pose by shifting down their projections of the appropriate federal funds rate path. Along with July’s rate cut, the shifts in the anticipated path of policy have eased financial conditions and help explain why the outlook for inflation and employment remains largely favorable.

Powell made no effort to shift expectations that the Fed would cut rates in September and in the process essentially nullified any of the hawkish noise coming from some of the regional Fed Presidents. I think Powell pretty much understands the situation and appropriate policy path.

Bottom Line: Powell and his colleagues are working to offset the direct risks to Main Street from sagging business confidence and the indirect risks from Wall Street turbulence spilling over onto Main Street. This means further rate cuts. We don’t know how many because we haven’t faced a situation where fiscal policy makers just will not take the hint. More than one, hopefully not so many that we are back to the zero bound. 

We Don’t Need a Broad Consensus

I am on vacation, but apparently can’t stop myself; more of a thought piece here on why we think broad consensus is important.

Reporting on the Jackson Hole conference, the Wall Street Journal’s Nic Timiraos brings us this

“For the chair, what you care about is agreement on the decision. You don’t care about agreement on the reasoning,” said Adam Posen, president of the Peterson Institute for International Economics in Washington. That created a limit to Mr. Powell’s ability to communicate clearly about why the Fed was cutting.

“He’s speaking for a committee that has multiple reasons for voting as it did,” said Mr. Posen. “It’s not good for Powell to pretend there’s more coherence or clarity than actually exists.”

I feel this view stands in contrast to what I would call the traditional view that the Fed needs a consensus framework to make and explain policy decisions.  The lack of a consensus about the reason for cutting rates is thus a “problem” that needs to be resolved for clear communications and the associated lack of consensus about the need for cuts means then that actual policy could be much more hawkish than anticipated without Powell’s firm guidance.

To be clear, my own analysis follows this line of thinking as it also consistent with the direction the Fed has taken in recent years, especially visible in the lack of policy dissents among governors and also I think in pursuit of clearer communications. Such a framework views a lack of consensus as a challenge to clear communications that can hinder the effective transmission of monetary policy.

Posen comes from a Bank of England background where policy dissents are the norm, not the exception. So from that perspective, the ability of Powell to pull together a very coherent and clear story really isn’t that important; it’s the final decision that is important.

I inclined to think that Posen is more right than wrong here and that we spend too much time caring about whether Powell has a consensus for policy actions or can clearly describe the reasoning for the action. At a certain point, why does Powell’s energy need to go into making everyone on the FOMC happy? To what extent does that slow the responsiveness of monetary policy? I am thinking of this given what I expect to be the breathless coverage of Fed presidents who don’t agree with another rate cut. The perceived need for consensus likely forces us to put too much weight on hawkish comments like today’s by Philadelphia Fed President Patrick Harker. Consider this, for example:

Nothing is moving dramatically in a negative direction. There is potential for it to do. And I think we need to keep our powder dry so when that happens we have the policy space to move.

This is just plain bad policy. It is essentially the same as saying the Fed should be hiking rates to create policy room for the next recession. It makes no sense to hold onto “dry powder” until something dramatic happens. At that point it is simply too late – you need to use your policy tools ahead of the drama, not after.

I am not so sure that there is much value to trying to cobble together a consensus view that incorporates the dry powder” contingent. Just like I think efforts to soothe former-Dallas Federal Reserve President Richard Fisher were a colossal waste of time. Why couldn’t we just let him dissent and then ignore him? Why keep alive a false sense of the need for broad consensus that gives some policymakers more influence that they should or do have?

Bottom Line: I am thinking about Powell’s lack of clarity in a different light. Whether intentional or not, Powell could be managing a paradigm shift that downgrades the need for consensus. That we get to the right outcome is what’s important; that everyone agrees on that outcome less so. Maybe our bias against 60/40 splits on the FOMC hurts policymaking more than it helps.

Rate Cut Coming Despite Thin Consensus For The Last

The Federal Reserve released the minutes of the July FOMC meeting today, revealing that only a thin margin of participants supported a rate cut at that meeting. The news failed to sway market participants from their belief that the Fed will cut rates again in September. Market participants are very much most likely correct on this point. At this point, the minutes have been overtaken by events.

The justification for the rate cuts had three parts: Decelerating economic activity tied to slower global growth and trade policy uncertainty, risk management associated with uncertainty to the outlook and limited policy space abroad to respond to slowing growth, and low inflation. The decision was far from unamimous as “several” participants wanted to hold rates steady given that the economy remained at a good place.  A few were concerned about the impact of easier monetary policy on financial stability.

On first blush, the lack of broad consensus on the reason for a cut or the need for a cut would seem to throw cold water on a rate cut in September. Still, market participants were unfazed by the news. I can’t say that I am surprised as circumstances have changed quite dramatically over just the past few weeks. I can see four reasons why the Fed will push through another rate cut in September even if some, like Boston Federal Reserve President Eric Rosengren, still resist such a move:

  1. Trade policy uncertainty has risen. Almost immediately after the July FOMC meeting, President Trump announced additional tariffs on Chinese goods, escalating the trade wars. Trump subsequently backed off somewhat but tensions remain high and there doesn’t appear to be a resolution in sight. And we all kind of know that even if there is a resolution, another trade dispute will follow. In addition, we have  policy uncertainty that expands beyond trade. For instance, Trump flip-flopped on the need for additional stimulus such as a payroll tax cuts. He has instigated an international incident because he was quickly – and expectedly – rebuffed in his interest in purchasing Greenland. Eventually this kind of policy randomness will undermine business confidence.
  2. Job market strength for last year was sharply overstated. The BLS today announced expected revisions to its nonfarm payroll estimates. For the twelve months ending in March 2019, the number of jobs will be revised down 501k, or, in other words, monthly job growth was 42k lower than believed over that period. This means that Fed rates hikes last year were predicated on an overly optimistic view of job growth as well as an overly optimistic view of the staying power of fiscal stimulus. The job market simply wasn’t as strong as was believed; the Fed should be thinking they need to correct for that error.
  3. Easier financial conditions flow from expectations of Fed easing. This line from the minutes kind of said it all:

    Participants observed that current financial conditions appeared to be premised importantly on expectations that the Federal Reserve would ease policy to help offset the drag on economic growth stemming from the weaker global outlook and uncertainties associated with international trade as well as to provide some insurance to address various downside risks.Expectations of further rate cuts help ease financial conditions and offset the negative impact of slower global growth and policy uncertainty.

    Realistically, if the Fed pulls back on those expectations by cancelling the September hike – which is viewed as 100% certain – they likely trigger a substantial tightening of financial conditions as market participants react negatively with increased concerns that the Fed is willing to let the economy drift into recession.

  4. Falling global rates and a stronger dollar. Falling interest rates around the world are helping to drag U.S. rate lower as well. I see Fed officials dismiss this as a “flight to safety” but that is exactly the point – if market participants are flying to safety en masse, then clearly something is happening that demands a Fed reaction. Falling global rates also suggest a falling r-star, which means that U.S. monetary policy is becoming tigher. The Fed needs to respond with lower rates. Finally, the dollar continues to gain strength, indicating tighter financial conditions as well as lower inflation. The Fed should respond with easier policy.

Bottom Line: At this point, I don’t really see that the Fed can walk away from a rate cut in September even if a substantial portion of FOMC participants would prefer to hold policy steady.

Note: I am on vacation for the last week of summer and postings will be light to nonexistent until the beginning of September.

Paving The Way To Rate Cuts

If You Don’t Have Any Time This Morning

The Fed will cut interest rates at least 25bp in September. This week, in Jackson Hole, Powell will hopefully define a path toward that rate cut and subsequent cuts as he seeks to sustain the expansion.

Newsletter version!

Key Data

A fairly busy past week for data revealed a solid yet unspectacular pattern of economic activity.It’s fairly clear that the manufacturing sector is weak at the moment. Industrial production is basically flat compared to a year ago; at the end of last year, the nation’s manufacturing activity was growing at a greater than 5% annual pace. Still – and importantly – the slowdown in the sector has yet to match that of 2015-16 nor does it even approach something consistent with a recession. I have said this before, but it should be said again: As manufacturing becomes a smaller portion of the economy, we should expect more instances of manufacturing downturns or even manufacturing recessions being separate from the overall business cycle.

In contrast, the much larger consumer sector of the economy continues to power forward. Retail sales sustained the rebound from turn-of-the-year weakness and core sales are again growing at a roughly 5% year-over-year rate, actually a bit higher than seen during the 2015-16 slowdown. The general continued strength in spending reflects the solid labor market. In my opinion, job losses need to mount before consumer spending will crumble. Low and steady initial unemployment claims indicate that those job losses are not yet on the horizon.


That said, University of Michigan consumer sentimentslipped to a seven-month low. Respondents reacted negatively to the Trump administration’s escalation of the trade wars. Between that and a reported negative reaction to the Fed’s interest rate cut, the report concluded that “is likely that consumers will reduce their pace of spending while keeping the economy out of recession at least through mid 2020.” I would be wary that any reported nervousness among consumers will have a persistent impact on spending barring job losses. It is easier to say that you will change your spending behavior than to actually change your behavior without a major life event to force that change.

Single-family housing starts rose in July although the multi-family sector pulled down the overall numbers. Single-family starts have largely recovered from the decline in the latter half of last year; lower interest rates had a positive impact on the sector as should be expected. Also note that although overall starts were down, permits were up. While I don’t think that housing will offer much if any positive contribution to overall investment spending, it also clearly is not falling apart as one might expect ahead of a recession.

Inflation came in hot; see my remarks here.


Not much Fedspeak last week as might be expected given the upcoming annual Jackson Hole conference. Still a couple of Fed presidents made the news.

Even though he doesn’t see an expansion, Minneapolis Federal Reserve President Neel Kashkari argued for further policy easing, saying that “[it] is better to be early and aggressive if you see a slowdown than wait until you’re sure the economy is in recession.” Kashkari also supported currently-embattled Federal Reserve Chair Jerome Powell while throwing shade on President Trump (via Bloomberg):

“Jerome Powell is an outstanding Federal Reserve chairman and an A-plus public servant and I think we’re all lucky to have him and I completely support him,” Kashkari said. “Very few businesses that I talk to are pointing to the Federal Reserve and saying ‘hey, it’s your interest rate policy that’s slowing things down.’ Much more likely it’s focused on trade policy and global uncertainty,” he said.

St. Louis Federal Reserve President James Bullard was more cautious in his policy prediction (interview here). Bullard viewed the data as solid and was not particularly concerned about the yield curve inversion. Via Bloomberg:

“Any inversion that is going to send a bearish signal for the U.S. economy would have to be sustained over a period of time, so we are going to have to wait and see on that,’’ Bullard said. “You have got this flight to safety going on’’ with foreign investors seeking the perceived sanctuary, and positive yields, of U.S. bonds.

Recall that Bullard has long expressed concerns about the yield curve – see back as far December 2017. Now though that the inversion is upon us, it’s all about it needs to be “sustained” and “wait and see.” The “sustained” part is interesting; the 3m10s portion of the curve first inverted in January, so it has already been sustained, so what’s Bullard waiting for? I would say Bullard is acting as someone might if they don’t really understand the flow of the data. The yield curve is a long-leading indicator; it will first come when the data is solid, as it is now (see me here). Because the data is solid, you get cold feet about reacting to the yield curve. But if you wait to act on the yield curve, as Bullard suggests, it will be too late to prevent a recession. You might as well not have indicated any concern about the yield curve in the first place.

In any event, Bullard will fall in line with the rate cut that is coming in September; he also made clear his concerns about declining market-based inflation expectations.

Upcoming Data

Slow data week. The highlights are existing home sales (Wednesday), Kansas City Fed manufacturing survey (Thursday), the usual initial unemployment claims report (also Thursday), and new home sales (Friday). The most important event on the calendar is Powell’s Jackson Hole speech on Friday.


The Fed is going to cut interest rates in September, even if they as of yet don’t want to admit it. That said, I don’t think they have a unified framework to justify and explain a rate cut and the lack of such a framework makes for a challenging communications situation.One description of Powell’s last press conference was that the rate cut was dressed-up in a “coat of many colors” to gain consensus for the action. It would be helpful for Powell to provide a more consistent policy vision with this week’s speech, “Challenges for Monetary Policy.”

As of last Friday, 30-year treasury rates were less than 1-month rates. That’s not exactly a healthy look for an economy that is supposedly “solid.” Not that the bond markets had much good news to begin with; the 3m10s inversion intensified this week and the 2s10s spread even briefly inverted. In my opinion these things are warning signs that monetary policy is too tight and will eventually crimp economic growth severely.

I think the Fed currently hesitates to embrace such an analysis. It sounds too much like they are taking marching orders from the bond markets;they typically like to place their actions within context of their policy framework. That framework, however, feels like it has fallen apart in the last six months. A critical part of that framework, the Phillips curve, is essentially on the back burner now that the relationship between unemployment and inflation looks relatively weak.

Downgrading the Phillips curve allowed the Fed to downplay the need for any further rate hikes. But there has yet to be a consistent story to justify the last rate cut, let alone more cuts. Powell pieced together a consensus for the last rate cut on the back of weak global growth, trade policy uncertainty weighing on business investment, muted inflationary pressures, lower r-star, lower estimates of the natural rate of unemployment, and the importance of sustaining low unemployment for as long as possible. Something for everyone. A coat of many colors.

It’s not clear that this will work to justify the three or more additional rate cuts market participants anticipate the Fed will deliver. The one thing that everyone can agree on to justify that magnitude of cuts would be significant concerns of imminent recession. But that’s not in the data and by the time it is in the data the recession will be on top of us. It would be too late to avoid a recession at that point.

If, as it increasingly appears, that Powell’s primary focus is on avoiding recession given that inflation has been persistently below target and hence not a threat, I think he will be seeking to create a path forward that defines a framework to justify multiple rate cuts and can be broadly supported by the rest of the FOMC.

In my perspective, it would be fairly straightforward to lean on the natural rate of interest to centralize an argument for further easing.The basic story would be that the Fed wants to sustain the current near-trend pace of growth and to do so they need to ensure that policy is not restrictive. But falling U.S. interest rates consistent with slowing global growth, low global interest rates, low inflation, and business confidence uncertainty, indicate that the neutral rate of interest, at least in the short-term, has fallen. This in turn leaves U.S. policy rates too high and likely even restrictive. You won’t see this in the data today, which reflects the level of monetary accommodation 6-12 months ago. You will see it, however, in 6-12 months unless the Fed adjusts policy rates accordingly. Hence, the Fed needs cutting interest rates in the months ahead to ensure that policy is sufficiently accommodative to sustain the expansion. Absent such accommodation, the economy will be excessively vulnerable to negative shocks such as trade policy uncertainty.

That said, this is pure speculation on my part. At a minimum, I expect that Powell’s will make clear that the Fed’s primary goal is to sustain the expansion. This will be viewed as verifying market expectations for substantial rate cuts in the next year. My read on the data and the yield curve is that the Fed can accomplish the soft landing and avoid a return to the zero-lower bound, but they first need to soon accept this requires them to cut another 50bp to 75bp.

Bottom Line: The Fed will need to cut rates next month even if they don’t yet know it. The faster they coalesce around the need for multiple rate cuts, the more likely it is that they will steer the economy away from recession.

This Is What I Am Talking About

It’s worth reiterating this point I made yesterday:

Given the long lead times, we can pretty much guarantee that we are not yet at the peak of this cycle and hence incoming data will likely remain solid albeit not spectacular.  The same good data flow could help prop up equities until the recession comes closer into view. The upshot is that an inverted yield curve does not mean a recession is right on top of us.

Today’s data is a perfect example of this point. Retail sales came in above expectation, proving once again the foolishness of betting against the US consumer:

and initial jobless claims remain low:

Until the job numbers turn in force, households will keep spending. Yes, manufacturing is on the weak side:

But this is completely expected and so far is mimicking the behavior of 2015-16 much more so than what you might expect in a recession. Moreover, while both the Empire and and Philadelphia business surveys came in well-above expectations, suggesting that the threats to manufacturing may be overstated. Also, I think we are learning that manufacturing might not be the signal it once was as the sector becomes a smaller share of the economy.

A generally positive tone to the data should not be unexpected; the inversion of the yield curve was never going to signal an immediate deterioration in the data flow. It is exactly that lag between signal and recession that has traditionally kept the Fed biased toward tightening after the yield curve inverts. This time the behavior of the Fed is very different. Time will tell if this means the Fed effectively kills the yield curve as a recession indicator.

Bottom Line: It remains too early to see a recession in the data. It’s reasonable to worry about the pessimistic signal from the yield curve but even if it does foreshadow recession, a recession call now is likely still too early. 

Don’t Panic. Yet.

OK, well that was kind of a crazy day. Equities gave up yesterday’s gains and then some as bond yields dropped. The 30 year bond yield hit a record low and the 10s2s spread slightly inverted, stoking fears of recession. In my opinion we should be reasonably concerned about the outlook as recession risks have risen but recognize that a.) the time between yield curve inversion and and recession could be long and b.) the Fed has been and will continue to be more dovish in the wake of the inversion than they have been in the past. On the other hand, the risk of continued chaotic policy out of the White House is high and could foster the type of coordinated pessimism that overwhelms the Fed.

Let’s begin by addressing this meme:

If economists at the Federal Reserve behaved this way, a 50bp cut at the September FOMC meeting would be a slam dunk. Remember, a yield curve-centric view of the world gives you a chart like this:

The Fed, however, will not be using such a simplistic model and will be wary that they can predict a recession a year or more in advance. Instead, they will look at the situation using more “actual economic data” and see something more like this:

Which means they will not be inclined to be as reactive to the yield curve as perhaps market participants desire. Remember, an inverted yield curve is a long leading indicator:

In the last cycle, the yield curve inverted in the beginning to 2006 while the recession did not begin until the end of 2007. Given the long lead times, we can pretty much guarantee that we are not yet at the peak of this cycle and hence incoming data will likely remain solid albeit not spectacular.  The same good data flow could help prop up equities until the recession comes closer into view. The upshot is that an inverted yield curve does not mean a recession is right on top of us.

On the second point, this cycle is unusual in that the Fed has cut rates already; in the past, they have continued to hike rates after a 10s2s inversion. I don’t like to say “this time is different” given the yield curve’s past predictive ability, but the Fed’s response is different, and only time will tell if the early response is sufficient to avoid recession.

Whether or not the Fed’s response will or can prevent a recession depends on the aggressiveness of the rate cuts and how much chaos comes out of the White House. The Fed can increase their odds of breaking up the building pessimism and supporting the economy with a bigger rate cut, but I don’t think they are there yet. First, as noted above, they might not see the need for an aggressive cut in the data. Second, they are facing enormous political pressure to cut rates and they may fear that a 50bp cut would be seen as yielding to that pressure.

Even if the Fed responds aggressively in the days ahead, we should be open to the possibility that they the situation evolves into something that overwhelms them. I say this as a believer in the capacity of monetary policy to influence the economy. Still, a sufficiently-sized shock might overwhelm the Fed. Consider this latest tirade from President Trump:

Realistically, Trump’s incoherent trade policies are the proximate cause for the pessimism building in the business and financial communities. Trump, however, would never admit to this and instead projects his anger onto Federal Reserve Chair Jerome Powell. We should recognize that if we stay on this path much longer, rumors will again swirl that Trump is going to fire Powell. I don’t think Powell would back down; the Fed would fight an attempted firing. I can’t imagine though that financial market participants would patiently wait for the matter to be settled in the courts. I think market conditions would turn ugly.

So one can make a reasonable story where the ongoing trade wars and a showdown with between the White House and the Fed erodes confidence and turns the business community sufficiently pessimistic to trigger a recession before the Fed can react or before their reaction has time to work it’s way through the economy.

Bottom Line: A yield curve inversion does not mean that a recession is on top of us or that it couldn’t be averted. It does mean that the risks of recession are higher. The Fed will cut 25bp in September with a risk of 50bp. Obviously if credit markets seize up before then we will be looking at the possibility of an inter-meeting cut. A lot of chaos is flowing from the White House now and fostering a negative feedback loop where red days on Wall Street increase Trump’s anger at Powell. The results could become unpleasant. 

Another Portion of Yield Curve Heading Toward Inversion

Stocks rallied and bonds fell as President Donald Trump blinked first on his latest round of threatened tariffs. Tariffs on many consumer goods are now delayed until December to prevent upward pressure on prices during the holiday shopping season. Although this in theory should relieve some uncertainty about the outlook, the yields on the shorter end of the curve rose less than on the longer end, pushing the 10s2s spread closer to outright inversion:

My instinct is to interpret this as indicating that the Fed is expected to be less likely to ease sufficiently to avoid a recession. Why might this be? One explanation is that since the Fed has tied trade tensions to rate cuts, the easing of those tensions in turn reduces the magnitude of expected cuts. A second explanation might be found in the other news of the day, the inflation numbers. Core-CPI inflation came in high for a second month:

If this keeps up, the low year-over-year numbers won’t be low for too long.  Market participants may be thinking that the Fed’s dovish shift won’t last long if inflation ticks up. Fed policy makers can say that their inflation target is symmetric, but they have yet to prove it is symmetric. We need some consistently above-target outcomes for the Fed to prove itself.

As far as easing trade tensions are concerned, I doubt the Fed will take much comfort in the latest developments. Yes, Christmas may have been saved, but that wasn’t the big problem. The Fed sees only small impacts on the aggregate economy from the mechanical impacts of tariffs; it’s the confidence effects on business investment that most worries the Fed. Those haven’t gone away and, if anything, are magnified by Trump’s flip-flopping. This anecdote via Bloomberg reveals the underlying problem:

“It’s too late and it’s not enough,” said Peter Bragdon, chief administrative officer for the Columbia Sportswear Co. “There’s continued chaotic policy making and incoherence coming out of Washington that makes it very hard for businesses in the United States to plan.”

Firms still face continued Trumpian uncertainty and consequently there is really no reason for the Fed to shift gears and think the associated risks have been mitigated.

As far as inflation is concerned, at least part of the firming inflation numbers are attributable to tariffs which, by themselves, should be viewed as one-time price shocks. Or, in the Fed’s preferred language, they have only transitory impacts on inflation. This is a very clear test for Powell & Co. They have quickly embraced inflation shortfalls as transitory. Will they do the same analysis if inflation exceeds target? I think that the Fed will error on the dovish side. That at least is what the Fed has been signaling.

Bottom Line: Neither of the today’s developments – “easing” trade tensions or higher inflation – should prevent the Fed from easing at next month’s meeting. I suspect though that they make it hard for the Fed to justify a 50bp cut in September. If the economy needs a more aggressive Fed response up front to prevent recession, then a lower chance of that outcome (now priced about 0%) should induce the longer end of the yield curve to flatten further and then invert.

On Rising Recession Probabilities

Economists increasingly worry that the next recession is closing in on the U.S. economy. Bloomberg, for example, reports that economists now see a 35% chance of recession in the next twelve months. Such roughly one in three odds of a recession suggests that while the baseline forecast of many economists is one of continued albeit slower growth, they see enough risks to the outlook that they need to hedge their bets against the possibility of more adverse outcomes.

I would say that these odds are notably high given that Wall Street economists – permabears excluded – generally hesitate to call a recession for three reasons (at least in my experience). One is that by definition if you aren’t in a recession you are still in an expansion and hence the data flow is generally reasonably solid. In other words, we generally lack the data to worry about a recession because of charts like these:

Here only industrial production is showing weakness but still less than experienced in the non-recessionary 2015-16 downturn. With manufacturing a smaller and smaller part of the economy, we would reasonably expect to see more of these sector specific shocks that have minimal impacts on overall activity.

A second reason economists hesitate to call a recession is because timing is everything on this call. Call a recession too early and you give up months if not years of potential gains. Given that recessions are relatively few and far between, the natural bias is to avoid the error of calling a recession too early. A third reason follows a similar line of reasoning. Recessions are nowadays fairly infrequent. There are not a lot of recessionary months in the data. With non-recessionary data the norm, forecasting models tend to spit out non-recessionary outcomes.

There is one class of model, however, that clearly currently spits out a very high probability of recession. That class of models is based on the yield curve and they tend to produce something like this:

I almost hesitate to post this chart as I fear I will see it all over bearish Twitter feeds when I wake up in the morning. That said, it isn’t exactly a secret. An inverted yield curve is a well-known harbinger of recession, one that I have often said you ignore at your own peril.

The current shape of the curve, however, is a bit unusual and throws a wrench into my analysis. I have long held a preference of the 10s2s spread as a recession indicator. Specifically, recessions tend to follow occurrences where the Fed continues to tighten policy even after the 10s2s spread inverts:

In only one of these four episodes did the economy manage to avoid recession at the end of a tightening cycle (we could add the 1998 rate cuts as another example, but I excluded in the interest of brevity). In 1995, the Fed stopped raising rates before the 10s2s spread inverted and soon turned to rate cuts. In the other episodes, rate cuts came too late:

I think one can argue that the Fed almost pulled off a soft landing in 1989 but policy proved to be still too tight when the economy, already struggling under the impact of the S&L crisis, was hit the oil price shock and Iraq War.

The current episode is unusual in that the 10s2s spread never inverted before the Fed began cutting interest rates. In that way it is similar to the 1995 story. But it is unlike 1995 in that the expectations of Fed easing have driven the short end of the yield curve into a fairly substantial inversion:

I find this to be quite annoying as I am not prepared for this situation. What’s the correct interpretation here? Should we take at face value the high recession probabilities generated by yield curve-based models?

My interpretation is that market participants have correctly anticipated the Fed’s reaction function with the expectation of substantial easing in the months ahead hence creating the inversion on the short end. This easing will be sufficient to derail impending recessionary threats. If the Fed’s easing was expected to be insufficient, I would expect that the 10s2s spread would be inverted.

Consequently, at this point I still do not expect a recession in the near year. Under my baseline scenario, the Fed’s upcoming rates cuts will slightly steepen yield curve and the picture will look like 1995. If the Fed remains a little too tight – doesn’t cut fast enough or deep enough – the yield curve will be flat to flirting with inverted like in 1989. The latter case would risk leaving the economy too vulnerable to negative shocks and it would be all too easy to see a geopolitical conflict pushing the economy toward recession before the Fed could react.

If recessionary shocks multiply now before the Fed reacts again, the 10s2s spread will invert before the end curve steepens as the Fed pushed interest rates down to zero. The most likely scenario to get there is that we essentially talk ourselves into recession as Trumpian uncertainty triggers coordinated pessimism that freezes business investment while the Fed is still pondering the data. I don’t see it there yet, but it is a reasonable story to tell.

Bottom Line: I agree with the assessment that risks to the economy have grown in the past 6 months. Boiled down to the essentials, the economy is slowing to trend and the multiplying downside risks leave it vulnerable to slowing below trend. The yield curve is telling me that these shocks will not overwhelm the Fed. Powell & Co. can still sustain the expansion and are expected to do so. “Expected” is key of course; the slower the Fed moves, the more likely they are to miss the opportunity to avoid recession. A policy error is a very real potential outcome here. To enhance the odds of avoiding recession, I would advise the Fed to get a 50bp cut done at the next meeting. While I fully expect the Fed to ease at the September meeting, at the moment the Fed seems likely to stick with the less aggressive 25bp cut.

Trade Wars Escalate

The big news everyone will wake up to is the latest escalation in the trade wars between the U.S. and China. The situation is obviously a clear net negative for the economy that will keep the Fed biased toward easing again in September. The Fed will remain under pressure to help President Trump fight his trade wars with lower interest rates in the months ahead.

Last week, Trump surprised market participants by announcing that 10% tariffs on another $300 billion of Chinese goods would go into effect on September 1. Tonight, China retaliated via two channels. First, the yuan fell broke through the 7 to a dollar barrier, trading down to 7.0256 at the moment. Importantly, the move was tied directly to the tariff threat. Second, China has asked (told?) state-owned operations to cease buying U.S. agricultural products.

The first move was obviously aimed at offsetting the costs of the proposed tariffs; the second move targets in particular the political base that supports Trump. The latter will be a particular blow to Trump given that the lack of commitment on agricultural purchases is reportedly what triggered Trump tariff’s threat in the first place. Via the Wall Street Journal:

Mr. Trump, who had a re-election rally scheduled in Ohio later that day, wanted to be able to assure farmers—who have been hardest hit by the trade fight as China scaled back purchases of U.S. corn, soybeans and pork—that he had at least secured concrete commitments from the Chinese that they would boost their purchases of U.S. agricultural exports.

But to his frustration, Messrs. Lighthizer and Mnuchin couldn’t give him any guarantees.

Tump got a commitment on agricultural purchases after all, although pretty much the opposite of what he was looking for.

I can only imagine that Federal Reserve Chairman Jerome Powell and his colleagues are quietly seething about the escalation of the trade wars. To be sure, at last week’s presser Powell was careful to not offer direct criticism of Trump’s trade policy:

…I want to be clear here. We play no role whatsoever in assessing or evaluating trade policies other than as trade policy uncertainty has an effect on the U.S. economy in the short and medium term. We’re not in any way criticizing trade policy. That’s really not our job.

Realistically though the Fed must be frustrated. They thought they had the economy pretty much dialed in and then Trump runs around like the proverbial “bull in the [C]hina shop” and threatens to screw the whole thing up. Worse, it is hard to not see that one reason Trump thinks he can make this play is that he believes the Fed, albeit reluctantly, has his back. To be sure, Powell did not say trade uncertainty was the only factor that drove the rate cut, but it seemed clear that it was the central factor. Recall also that the Fed’s pivot toward easing came suddenly after the threat of tariffs on Mexico.

Couple of things here. First, the Fed is doing the right thing by easing in response to the tariff-related uncertainty. It is their job to offset shocks to the U.S. economy. Second, I think that if Trump believes the Fed will be able to bail him out entirely, he is likely badly mistaken.

Think of it this way: At a very basic level, tariffs will create a fresh set of winners and losers in the economy but at least via direct channels have a fairly small direct effect at the macro level. Back to Powell:

You know, the mechanical effects of the tariffs are quite small. They’re not large as it relates to the U.S. economy. The real question is what are the effects on the economy through the confidence channel, business confidence channel. And again, very, very hard to tease that out. I’ve seen some research, which, you know, which says that they are meaningful, meaningful effects on output as to say not trivial. And I think that that sounds right, but it’s quite hard to get—there is no way to get an accurate measure…

Assume that the Fed can largely offset the tariff and confidence effects on the macro economy via easier policy. This, however, will not necessarily reverse the relative impact on winners and losers. In particular, a significant contingent of the losers of the trade wars are in Trump’s agricultural base. I doubt the Fed easing would do much to directly offset that loses that they are about to suffer. Hence, I think the Fed’s power to bail out Trump may be somewhat limited. His base will still get hurt.

At the press conference, Powell also laid out the script that financial market participants are already following. As I write, yields on the 2- and 10- year treasury bonds are both down 7 basis points to 1.64 and 1.78, respectively, and odds of a 50bp point cut at the next meeting have jumped to roughly 30%. The Fed will be in a difficult position this week. If Fed speakers emphasize the trade risks, they will reinforce expectations for that 50bp cut. But they can’t really avoid the trade risks, or downplay them in this market, so I am not sure they can avoid that outcome. Only an easing of trade tensions can help them at the moment.

Bottom Line: Continued trade uncertainty means the baseline scenario is that the Fed eases again in September.