We’ve been hyper-focused on the equity market over the past few months so I thought we’d expand our horizons today and look at a few other markets, particularly the bond market. This discussion should dovetail nicely with recent central bank comments suggesting an alteration of their inflation policy framework – something that could have large consequences down road.
To set the stage, I’d like to remind you of a frequently expressed belief of mine, which is that the yield on the 10-year note acts as something of an economic speed limit. In previous articles, I’ve detailed how this benchmark rate tends to track the sum of real GDP growth and inflation.
As a result, we know that the yield on the 10-year note is a good reflection of underlying economic prospects; when it’s moving higher, economic growth and inflation are generally rising, and when it falls, it reflects a slowdown (actual or anticipated) in one or both of these metrics.
In the chart below, we can see the S&P 500 at the top, and the yield on the 10-year note below it. (As a quick aside, I’ve thrown in major support and resistance levels in the S&P chart to highlight the fact that we’re currently bumping up against strong resistance. The 2800 level has held the index back on three separate occasions in 2018, and is exerting its influence once again.)
Getting back to our discussion on rates, in the lower panel you can see that while stocks have rebounded sharply during 2019, the benchmark 10-year yield has not. It has been flatlining in a range from 2.65% – 2.75%.
This suggests that while investor sentiment has rebounded and pushed stock prices higher, underlying fundamentals have not shifted dramatically; either real GDP growth, inflation, or both, remain under pressure. This outlook meshes with our discussion from last week, which highlighted the growing divergence between price action and economic data.
Moving on, and continuing to use this notion of the 10-year yield as a speed limit, we also know that inversions of the yield curve are reliable precursors of economic malaise. When shorter dated maturity Treasuries (specifically the 2-year or 3-month) rise above the 10-year, it signals a strong likelihood of recession within the next 6-18 months.
When this occurs the Fed has tightened financial conditions in excess of what the economy can bear. The result is a slowdown or outright contraction in growth, typically also accompanied by a decline in inflation.
Before we get too far down the road I want to highlight just how close we are to seeing this. In the following chart the 10-year yield is shown in blue, with the 2-year yield displayed in red. The two are currently only about 25 basis points apart, so it’s a good thing the Fed has signaled an intention to hit the pause button on rate hikes …
But this leaves the Fed in an interesting predicament. With the secular downshift in the economy’s speed limit on clear display in the chart above, the Fed has much less room to operate these days. This assumes of course that policy rates are bounded at zero (which is a topic for another day), but I think at least for now it’s fair to say that the Fed’s goal is to not have to implement a negative rate scheme if at all possible.
So then how does the Fed go about getting some additional breathing room? Well … they change their stated inflation target. This might sound a little abstract at first, but hopefully it’ll make more sense as we talk through it.
To again set the stage, it’s important to understand that the Federal Reserve’s congressional mandate is to promote maximum employment and price stability. The price stability component of this dual mandate has largely been left up to the Fed to define. Back in 2012, the Fed formally adopted the 2% inflation target that we know today. Prior to that, they operated under an informal target range that was thought to be 1.7% – 2.0%.
When the 2% target was officially adopted, the Fed justified it by saying:
Communicating this inflation goal clearly to the public helps keep longer-term inflation expectations firmly anchored, thereby fostering price stability and moderate long-term interest rates and enhancing the committee’s ability to promote maximum employment in the face of significant economic disturbances.
So in reality, it’s only been seven years that we’ve had a formal 2% inflation target, and now we’re hearing murmurs that the Fed wants to loosen this objective. Why would they want to loosen it? Because in addition to the factors already mentioned, the Fed has largely been unable to reach this target.
Ever since the financial crisis, headline inflation has made momentary appearances above the 2% mark, but core inflation – a better gauge of underling price pressures – has remained at or below that level the entire time (see chart above).
Now, this might not sound like a bad thing, as most people see inflation as an enemy. It erodes the purchasing power of your hard earned dollars, after all …
But when you change your focus to that of an entire economy, especially one that is both reliant on debt for growth, and also saddled with significant levels of debt, inflation starts to look a lot more like a friend. This is because inflation erodes the value of outstanding debt, making it less onerous to the current economy. As Richard Russell used to say, “Inflate or die!”
So what’s this new framework that the Fed wants to introduce? The specifics are still being hammered out, but the gist is that the Fed wants to move to a policy framework that looks at inflation over longer periods of time, rather than just one point in time. There are two ideas currently being discussed.
The first is to move to a price-level targeting mechanism. This means that if inflation undershot 2% one year, the Fed would try to overshoot by a similar amount the following year. In essence, a 2% figure would be used to compound prices levels each year from their current levels (thereby setting the price level target), and inflation would be allowed to run as hot as necessary to then reach that target.
The second approach involves an “average inflation target,” which is the idea that instead of shooting for 2% inflation at any given moment, they attempt to reach a 2% average inflation level over the entire business cycle. This would also entail letting inflation run hotter during expansionary periods to make up for the shortfalls in inflation that usually accompany recessions.
Regardless of which approach the Fed adopts, both of these advocate more dovish monetary policy (lower rates for longer). They also promote higher levels of inflation than we’re seeing currently, which, as mentioned before, acts to alleviate some of the debt drag on the economy.
Alright, now let’s discuss some of the implications of this …
One of the first things we need to recognize is that by allowing inflation to run hotter, it will theoretically increase the yield on the 10-year note. Recall that this yield tends to track the sum of real GDP growth and inflation, and by allowing for more inflation, the Fed is, in a roundabout way, increasing the “speed limit” under which they must operate.
This would allow them to raise short-term rates higher than they’re able to now without inverting the yield curve, which would then correspond to more room to cut when the inevitable downturn arrives. To provide some context as to why this is important, the Fed has cut rates by roughly 5 percentage points in each of the last three downturns. They only have about half that breathing room now before they bump into the zero bound.
Another secondary “benefit” to this approach is that it could lead to less reliance on unconventional monetary policy, including both negative interest rates and the use of quantitative easing. Ongoing discussions suggest that at least a few Fed members doubt the efficacy of QE.
Finally, one of the most important factors that sits behind this decision has to do with inflation expectations. Recall that it is not so much current inflation levels that drive economic behavior, but the perception of future inflation levels. When economic participants believe inflation will remain low or decline, there is no incentive to make purchases now. This results in reduced economic activity and can itself lead to a downturn in the economy.
On the flip side, when inflation is expected to rise, it induces these same participants to make their purchases now, thereby driving economic growth. This notion that prices will always continue to increase is important to the behavioral patterns that dictate how our economy functions. This is why central banks are rightly concerned about the prospect of a deflationary spiral. No matter what, prices must continue to march higher.
What’s particularly interesting about this dilemma is how the Fed’s guard has changed over the last few decades. Following extremely high inflation levels in the 1970’s, the central bank’s main goal when setting (informal) inflation targets during the 1990’s was to establish expectations that future inflation would be tame.
Now that inflation has been tame for so long, and tamer than deemed appropriate, the Fed’s guard has shifted towards trying to protect against too low inflation. In my humble opinion, this will be the Fed’s modus operandi for the foreseeable future. The days of runaway inflation are behind us, and as we become more and more debt ridden, modest inflation becomes not just a benefit, but a necessity.
As we wrap up this discussion I should note that none of this has made its way into the Fed’s policy playbook just yet … these discussions are all preliminary and in response to a extensive review of its policy framework that begins this week. My goal in discussing all of this is simply to give you a preview of what’s to come, and why.
I realize we’re running long, but I have a few additional comments regarding the stock market. We’ve been stuck below overhead resistance for the last week (see first chart in this article), but some indications suggest we may soon take out that level.
Today we saw the final Markit services PMI reading for February, which came in at 56.0, signaling solid expansion. We also got a reading on the ISM services index, which handily beat expectations at 59.7%. In addition, we’re seeing a snapback in housing, as new home sales came in well above expectations. This is no doubt a response to the decline in interest rates we examined earlier.
In addition, a look at the VIX, aka. fear gauge, shows that option markets are not pricing in large expected moves. This could be a sign of complacency, but right now stock market protection is not in high demand.
This doesn’t necessarily mean that the market will move substantially higher (I still think we could be rangebound for some time) but it suggests that the likelihood of a big drop from current levels is low.
As time goes on it’s really starting to appear that the December meltdown was in large part a function of the Fed’s hawkish stance, and now that the Fed has done an about face, risk appetite is back. If the Fed does indeed implement an even more dovish stance by changing their policy framework, it could add more fuel to the fire.