Back in December 2015, just days before the Fed hiked rates for the first time since the global financial crisis, in its first tightening campaign since June 2004, we said that Yellen was about to engage in a great policy error, one which like the Ghost of 1937, would end in disaster...
... and sure enough it did, when after 9 rate hikes, Powell realized that a rate of 2.50% is unsustainable for the US economy which first cracked during the summer of 2019 repo crisis when the Fed cut rates three times, only to cut rates to zero from 1.75% in a matter of days after covid conveniently emerged on the global scene and led to an overnight shutdown of the US economy and "forced" the Fed to nationalize the bond market as well as inject trillions of liquidity into the market.
But what is it that prompted us to predict - correctly - that any rate hike campaign is doomed to fail (similar to the Fed's ill-conceived plan to hike rates in 1937, which brought the already reeling country to its knees and only World War 2 saved the day, giving FDR a green light to unleash a fiscal stimulus tsunami the likes of which we hadn't seen until the covid response)?
Simple: as we explained back in Dec 2015, the equilibrium growth rate in the US, or r* (or r-star), was far far lower than where most economists thought it was. In fact, as the sensitivity table below which we first constructed in 2015 showed, the equilibrium US growth rate was right around 0%.
As we explained then making the case for a far lower r-star, "if nominal growth is 3 percent and the debt GDP ratio is 300 percent, the implied equilibrium nominal rates is around 1 percent. This is because at 1% rates, 100% of GDP growth is necessary to service interest costs."
In this case, real growth would slow in response to rate hikes because productivity would stay weak at full employment and companies would be profit/price constrained around paying higher wages. Moreover, nominal growth would then slow even more than real growth does because inflation would fall to 1 percent or below.
As we concluded then, "this is the important policy error scenario because even a very shallow path of rate hikes might drive the real Funds rate well above the short-term equilibrium real rate, further depressing demand. It is then plausible that the economy would be driven into recession, and the Fed would quickly be forced to abort the hiking cycle. As an aside, such a policy error could reinforce itself by causing structural damage that puts additional downward pressure on the equilibrium real rate. In this case the yield curve would flatten meaningfully, at least until the Fed actually reversed course by cutting rates."
As the chart at the top shows, this is precisely what happened, only instead of World War II - which is what short-circuited the Ghost of 1937 rate hike policy error, it was the covid crisis that gave the Fed and the US government a green light to unleash an unlimited monetary and fiscal stimulus, delaying the inevitable recession and kicking the can a few years.
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Why is all of this relevant? Because according to some of the smartest people on Wall Street, the market's reaction to last week's unexpected Fed announcement suggests that r* now is even lower - which makes intuitive sense in light of the surge in debt and decline in growth excluding government stimulus - and that the next tightening cycle, which may start as soon as next year according to Bullard - will be the shallowest one yet as the US economy can hardly afford tighter financial conditions.
In a note written late last week, and certainly after the market's remarkable reversal following the hawkish Fed, DB's chief FX strategist George Saravelos wrote that the day after the Fed meeting "was extraordinary by any measure: the biggest daily rally in the dollar index since the March global shutdown, a big drop in long-end US yields to the lowest since February, the biggest drop in some commodity prices since March of last year but a new record high in the NASDAQ all happening at the same time."
How to square it all up?
According to Saravelos, the Fed made a big policy error as evidenced by the flattening in the yield curve...
... which according to the DB FX strategist "boils down to a very pessimistic market view on r*" or in other words, the same argument we made 6 years ago when we predicted that the Fed's hiking cycle would end in disaster.
First, the easy part. The big dollar rally is entirely with the conventional wisdom that what matters for the greenback is front-end real rates. Fed tightening expectations have repriced sharply higher over 2023 and support more near-term dollar strength (chart 1). There should be no surprise that the dollar has rallied strongly even if 10-year yields have not made new highs.
Second, the commodity part. As the DB strategist notes, the role the Fed has played in inflating commodity prices should not be underestimated and is perhaps seen best in the very high correlation between the dollar and base metal prices at the moment:
Our fixed income colleagues have shown there is an extremely powerful link between the Fed balance sheet, commodity prices and inflation expectations: the taper of 2013 marked the peak in inflation expectations back then too.
On a similar note, economists have shown that even survey-based measures of inflation expectations such as Michigan exhibit a high correlation to commodity prices. All of this reinforces the point that the Fed can be far more powerful in influencing inflation expectations via
the dollar and commodities than is commonly assumed.
Finally, and most importantly, we get to the bond and r* part.
As the chart below shows, the market has undergone a remarkable twist flattening over the last 48 hours which according to Saravelos is extremely unusual given that the Fed has not even started hiking rates yet. And in a repeat of the aborted hiking cycle of 2015-2019, while market pricing for hikes in 2023 and 2024 has gone up, yields beyond that have gone down as the market is saying that the best the Fed can do is less than 2-years of rate hikes.
This has also coincided with a notable drop in inflation expectations - indeed Fed has shown a hawkish pivot even before market breakevens have reached their pre-2014 normal range.
What all of the above is telling us, according to Saravelos, is that unlike 2015 when we were the only ones warning about how low real r* is, the market now is taking an extremely pessimistic view on real neutral rates, or r*.
Said otherwise, if the Fed decides to go early - as first Powell hinted and then Bullard doubled down on Friday sending stocks plunging - the market is saying that it won’t be able to go very far before inflation and growth hit a speed limit, pushing yield expectations after the initial hike lower.
This very pessimistic view on r*, first laid out here in 2015, is also in line with market behavior beyond the bond market. First, as DB's Saravelos notes, it is aligned with the very high dollar responsiveness we have seen to even small shifts in Fed stance: huge pent-up demand for yield from investors across the planet forces a stronger dollar and a bigger disinflationary impact quicker than assumed.
In other words, a low global r* (remember the rest of the world still has massive current account surpluses, or excess savings) pushes US r* even lower.
Second, a low r* is consistent with continued equity resilience, especially in growth stocks heavily reliant on a low medium-term discount rate. That the equity moves in the past two days were led by huge relative rotation from the Russell to the NASDAQ should not be a surprise. This, as Deutsche Bank ominously warns, is 2010-19 secular stagnation pricing, version 2.
Bottom line: while a day’s price action (or even two) does not a trend make, the market is sending some peculiar signals that need to be monitored. Meanwhile, Saravelis has been emphasizing in recent weeks that the transition away from the v-shaped part of the recovery to the new post-COVID steady state will start raising all sorts of uncomfortable questions, including the structural damage COVID has left on private-sector saving rates as well as the new level of equilibrium real rates. One can only imagine the sorry state of the economy when the fiscal stimulus is gone and turns from a tailwind to a headwind. Historical evidence has shown a huge negative impact of pandemics on r* for example. For a big dollar up cycle, the Fed needs to be able to get very far. The market is not so sure, although for now the paradoxical divergence between the surging dollar and tumbling yields has yet to be addressed by the market.
A bigger question is will the US even be able to sustain positive GDP growth absent trillions in new stimulus each and every year? And even more ominous: what happens to inflation if the Fed is forced to cut rates well before the inflationary burst is extinguished? These are among uncomfortable questions markets will have to answer in the coming months.
Perhaps the biggest question facing the Fed now is whether it is about to do another huge "ghost of 1937" error. As a reminder, the Fed believed the US economy had turned the corner in 1937 and started to raise rates – and was wrong, bringing the economy to its knees again. Only the massive fiscal reflation sparked via World War 2 saved the day.
The problem is that this time we already had the covid "war" which pushed both the US debt and deficit to wartime levels, so what else left absent all out war with China? How else can the US government justify tens of trillions more in stimulus at a time when the market is already discounting the US economy hitting a brick wall in 2024 when the next rate hike cycle comes to an end. And how will Powell's replacement (the Fed chair will certainly take the first opportunity to get the hell out of Dodge) combat inflation when some time in 2024 the economy enters recession even as prices continue to rise?
Because while Saravelos is right that the market freaked out as a result of a "very pessimistic" take on r*, a far more appropriate question is whether we are on the precipice of non-transitory runaway inflation as the Fed's hands will soon be tied and its attempt to stem soaring prices will push the US into economic depression?