This post was originally published on Patreon on 30 May 2018
Yesterday I said that I believed the Italian meltdown presented a buying opportunity because it was not existential. And today, calm has returned, actually sooner than I had expected. The Italian government bond auctions have gone well. The flight to safety has reversed much of its move. And stocks are rising again.
So I want to say more about the model I use to think about the economy and financial markets – and what we are seeing right now.
It’s pretty simple, really. Basic econometrics do a very good job of telling us where an economy is headed over the medium-term because economic modeling is sophisticated enough to feed macro data in and spit out and range of likely outcomes. And if an economy is humming along at 2-3% annualized real GDP growth as the US economy is now, the range of likely outcomes is small enough that we can exclude recession as a likely possibility.
Where the rubber hits the road on predictability is when the economy moves down into stall speed, below 2% annualized growth. That’s because an economy then is slow enough that the range of likely outcomes then includes ones where GDP growth can go negative. Below 1% growth and the potential for recession increases dramatically.
The way I am looking at this then is as an economy on a specific economic trajectory, buffetted by economic shocks that throw it off that trajectory. For example, late last year, the deficts due to the Trump tax cuts took the U.S. economy and hitched it up a notch, say 0.3% annualized. That’s an economic ‘shock’ of 0.3%.
Equally, had Trump imposed tax hikes of an equivalent magnitude on US businesses and households, we would have seen a downward shock. But that shock would have been insufficient to risk recession for an economy greowing well above 2%.
So you need both the economic shocks and you need the economic vulnerability to produce an existential threat to the economy and, by extension, to markets.
The Italian crisis isn’t going to get us there. Major economies are growing too robustly and the reasonable worst case scenarios from Italy over the medium-term are not enough of a shock to the financial system to cause the kind of turmoil we saw during the original sovereign debt crisis. That’s why the turmoil in Italy presented a buying opportunity.
At the same time as I look at the macro factors, I am also looking at market-based economic proxies like the yield curve. What I have been saying is that a flat yield curve is by itself not a signal of impending economic weakness. After all, we had the greatest cyclical bull market in history in the late 1990s when the yield curve was as flat thorughout the entire period as it is now.
A flattening curve is a sign of tightening, not of economic weakness. It says that financial conditions are becoming relatively less accommodative. Whether that tightening leads to a slowing economy is a second order effect. Again, look back to the 1990s as the US raised rates to see how this played out. Similarly in the 2000s. It’s when the curve inverts and stays inverted for a couple of months that we have to worry.
Now, if you take my stasis-shock model of the economy and apply it to market-based signals, it also puts what has happened in Italy into perspective. We went from a yield curve with US 10-year bonds trading more than 55 basis points wide of 2-year bonds to a differential of 44 basis points overnight. Italy caused the curve to flatten by more than 10 basis points. And while the flattening has unwound somewhat, we are still around a 47 basis point spread.
What this demonstrates is the magnitude of a shock and how it manifests itself in terms of market-based signals. For example, imagine the curve had been at about 15 basis points instead of 55. Italy would have tipped us to about 5, with the Fed due to increase rates 2 or 3 more times this year. All it would take from that point is a few more shocks from inflation figures or wage growth or GDP growth to tip the curve into inversion.
So the Fed doesn’t have to invert the curve. The Fed merely needs to remain on a tightening path with the curve steepness below 25 basis points. And the markets would take the curve into inversion. At that juncture, the Fed would be faced with a choice of continuing its tightening guidance or of relenting and reading the inversion as a signal of coming economic weakness.
This is the path we are now on. The curve is not flat enough yet to make this a concern. But after June’s rate hike it may well be flat enough. And then we will be in a position where negative economic surprises tip the curve into inversion.
At the moment, I am expecting this to be how the second half of 2018 plays out. But even if we get there and the curve inverts, we would still likely have a number of months before that signal was made manifest by recessionary data flow.
For now, focus on the next jobs report released on Monday. With the Italian crisis potentially fading, only US domestic economic data will matter to the Fed regarding its tightening guidance.
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