This post was first published on Patreon on 19 Jun 2018
Since I havent written in several days, there are a number of different threads I want to consider as I post today. So this is going to be a thematic post to connect a few threads into one idea. And that idea is that the threats to economic growth are multiplying.
Some of these threats are ones that can slow growth. Other threats will make growth re-acceleration more difficult once growth slows. I am still looking at this as a 2019 threat, however, and expect robust US growth in the near term.
The yield curve says the Fed may end up too hawkish
The biggest threat to growth is the Fed. I have been writing about yield curve compression for seven months now. I started in November explaining why the flattening yield curve didn’t worry me. And I wrote that I would sooner expect economic acceleration than recession or slowdown. And that’s been the right call. GDPNow for the present quarter is still tracking 4.8% with half of the quarter’s data already in.
But that was when the spread between 2- and 10-year bonds was 70 basis points. That spread has narrowed to 36 basis points. I believe it will narrow further still, to 25 basis points. Go out to 30 years and the 2-30 spread is now 49 basis points, the lowest since 2007. That’s a signal that the market does not expect Fed hawkishness to last. And that is due to anticipated economic weakness.
The case I started to make in December was that the Fed has been and probably will be more hawkish than you think. As I put it then:
The unemployment rate has hit levels that make the Fed uncomfortable. Several Fed officials have said that the Fed needs to act pre-emptively to prevent inflation from rising. And since multiple Fed officials have recently suggested that we are at full employment in the US, the bias at the Fed is clearly toward tightening. With a tightening bias, the Fed will stick to its forecasted rate hikes unless we see significant weakness in economic growth.
Higher growth means higher interest rates
I expected the US economy to slow by mid-year. The Trump tax cuts have put the kibosh on that forecast. US growth acceleration has continued for longer, with no obvious end in sight. That means a more hawkish Fed and higher rates. What was three rate hikes in 2018 is now four. And if the unemployment rate drops more quickly than the Fed anticipates, expect 2019’s timetable to also accelerate.
Herein lies the threat. We are in the most dangerous period in the business cycle. And that’s simply because policy error is much greater when the Fed is in a hiking cycle. Jerome Powell and Lael Brainard have already downplayed the yield curve as an economic signal. They are fully focused on the declining unemployment rate. They are concerned about falling behind the curve, not causing the next recession.
Since monetary policy acts with a lag, the hikes now being made won’t be fully felt until a year, 18-months down the road. And by then, we could be in a completely different situation economically.
The trade war is becoming serious
The threat of tariffs on an additional $200 billion of goods imported from China to the US could unwind all of the incremental growth from tax cuts. What we saw from Trump with tariffs on Canada and the EU was more posturing than anything serious economically. It was a warm-up to the Chinese. But now we are playing the real game. And Trump thinks he can bully the Chinese into submission. His view is that the US, as the deficit country has all of the leverage because a trade war will hurt China much more than the US.
But we don’t want a trade war. Trump’s logic only works if Chinese leaders capitulate due to their worry about the impact of tariffs on the Chinese economy. But politicians always play to their domestic audience. And caving to Donald Trump may not be the best political bet for the Chinese.
So let’s play this out. First, $250 billion of goods to apply tariffs to is a lot. Let’s assume China doesn’t play nice and matches Trump’s initial $50 billion tariff move with their own. Then Trump will be forced to find an additional $200 billion of goods to apply more tariffs to. That’s half of Chinese exports to the US. There is no ready substitute for many of those goods from China. So there’s no way US consumers can avoid paying more for goods when the tariffs are so broad.
Second, China doesn’t import that much in goods from the US. And while Trump thinks this is to his advantage, it will also force China to use other means to respond to Trump’s tariffs. They will erect regulatory, non-tariff barriers for US companies operating in China. You might see a boycott of American firms, tacitly supported by the government. There are a lot of ways China could respond — both economically and geo-strategically.
What does the Fed do then? By the time any of this bites, the Fed’s rate existing hikes will already be feeding through. And more hikes will likely happen before the magnitude of the tariff war becomes clear.
The threat is that the economic slowing from tariffs come just as the economic slowing from the Fed’s hikes come to the fore. That’s a 2019 scenario.
Banks are overpaying dividends
All of this is occurring just as the underreserving at banks has begun. It’s been a whole decade since we’ve had to talk about banks underreserving for future credit losses. But it always happens at the end of the business cycle. And the underreserving is a big factor in the contraction of credit availability as recession takes hold.
Here’s how Bloomberg is covering this:
Harsher Federal Reserve stress tests this year won’t stop U.S. banks from increasing their payouts to shareholders.
As the annual review gets under way this week, the 25 largest lenders are gearing up to announce dividends and buybacks totaling roughly $30 billion more than last year, representing a 25 percent increase, according to analysts’ estimates compiled by Bloomberg.
JPMorgan Chase & Co., Bank of America Corp. and Citigroup Inc. are likely to distribute more than 100 percent of their profits in the next four quarters, according to the estimates.
So, just as a potential recession is coming, banks are paying out more than they earn. This will provoke a nasty pullback in credit as banks look to preserve capital once the credit cycle turns.
We are late cycle in credit
I expect the credit cycle to turn very soon. One area I am watching is commercial real estate. And the dynamics in that market are similar to what they were in 2007, just before the global economy went into a recession.
Commercial mortgage bonds are getting stuffed with the lowest-quality loans since the financial crisis by one measure, according to Moody’s Investors Service, a warning sign that the $517 billion market may be headed for harder times.
The securities are backed by as many interest-only mortgages as they were in late 2006 and early 2007, Moody’s said. Those loans are riskier because borrowers don’t pay any principal early in the debt’s life. When that period expires, the property owners are on the hook for much higher payments.
The percentage of interest-only loans in a commercial mortgage bond is an “important bellwether” for the industry, according to Moody’s analysts, because the loans are more likely to default and to bring bigger losses to lenders when they do. Underwriters aren’t taking steps to fully offset the rising risks, the ratings firm said.
When these loans go bad, the banks now paying out more money than they are making will make less money and they will need to reserve more for future losses – a double whammy. Those days are coming very soon.
So when does this cycle turn?
The big question is when the business cycle turns. And that depends very much on the Fed. We saw what happens in an overextended sector like shale oil when market dynamics go into reverse. But that was without a Fed rate hike train. It’s the Fed’s hikes that will overextend Ponzi borrowers and create Ponzi situations for speculative borrowers as risk spreads increase.
The market was largely prepared for the four rate hikes the Fed will deliver this year. But, it is not prepared for a further acceleration beyond that. I believe we will get acceleration as the unemployment rate drops further. The yield curve will compress and eventually invert. Credit spreads will begin to widen and defaults will rise.
This is a 2019 outcome. For now, it’s smooth sailing economically. But when this cycle turn, it will turn hard. Monetary firepower will be limited. And given the gaping deficits created by tax cuts, the fiscal response will be limited too.