TIMING & MAGNITUDE

The head of the self-proclaimed “authority on bonds” says the rate hikes are history. PIMCO’s Bill Gross wrote in his October Investment Outlook that “the Fed is done and ultimately will have to lower interest rates in order to restimulate an asset based/housing led economy that has been its primary growth hormone in recent years.”
The underlying assumption in his projection is that inflation is “leveling off” and the economic growth rate is “moving towards a 2% real growth rate or less in the next year or so….” As such, the Fed “at some point in 2007 will be forced to cut short rates.” Timing and magnitude are yet to be determined, he adds.
In fact, the future may be more complicated than it appears. Economist Robert Dieli of NoSpinForecast.com documents the finer points of this complexity by plotting the history of economic cycles against instances of inverted yield curves. As he illustrates in the chart below (which, alas, we’ve squeezed a bit from the original to fit into the confines of CS), there’s a lengthy history of yield-curve inversions accompanying economic contractions and a drop in the Fed funds rate shortly after the yield inversions arrived. But that doesn’t mean the past is prologue, at least not a prologue that’s clear and obvious.
Federal Funds Rate. Red Squares Denote Periods when the Fed Funds
Rate was Higher than the Long Treasury
100206.GIF
Source: NoSpinForecast.com

In any case, the last example of rate hikes and recession came early in the 21st century, identified on the above chart by “11.” The red dots indicate moments when Fed funds were higher than the Long Treasury, defined here as the 20-year Treasury. As Dieli noted in the accompanying research report, “There are no cases of a yield curve inversion ending without a drop in the Fed Funds rate from the peak level attained in each episode.”
(As a quick digression, the two red dots between episodes 10 and 11 were, Dieli told us this morning, were byproducts of the anomalous events associated with the implosion of Long Term Capital Management and the Treasury’s decision to stop selling the 30-year.)
Ah, but what about episodes 8 and 10? Note that the Fed funds took flight in each of those cases without a commensurate yield-curve inversion, suggesting, if nothing else, that sometimes the central bank achieves something close to perfection in monetary policy. Indeed, in 8 and 10, long rates took wing but without triggering a yield curve inversion or recession.
Episode 10 is near and dear to investors’ hearts. The moment came in 1994, when then-Fed Chairman Alan Greenspan elevated rates and delivered the much-sought-after but rarely delivered soft landing by way of higher rates sans recession. It was, in sum, one of Greenspan’s finer moments. As Dieli wrote, “In episodes 8 and 10, the two successes, the yield curve did not invert, which allowed the FOMC to lower rates to complete the implementation of a policy accommodative of further noninflationary growth, thereby burnishing the reputations of Chairman Volker and Chairman Greenspan.”
We are now firmly in the world of Episode 12, which admittedly has yet to fully play out. While the world guesses what comes next, there is at least one absolute to consider: the yield curve inversion. Fed funds today are 5.25% and the 10-year Treasury yield resides at a materially lower level of 4.63%, as of Friday’s close. Beyond that, clarity necessarily blurs.
Dieli worries that episode 12 may become episode 3, which, as the chart shows, was a moment when the Fed had apparently engineered a soft landing. In fact, the early signals were misleading. The central bank hadn’t tightened enough to battle inflation, and so was forced to reverse course soon after by raising rates once again, which led to a recession.
The issue, as Dieli sees it, is that the bond market has no fear of death at the moment. “I can’t imagine the bond market feels any particular threat in holding long positions,” he tells CS today. The problem for Bernanke and company boils down to answering this question, as put forth by Dieli: “How do you convince the bond market that you’re done without starting a recession?” The history of the past 20 years suggests that bringing down the core rate of inflation requires a recession. Will that history hold? Or is something new and relatively unprecedented waiting in the wings? The incentive for answering “yes” typically comes from looking to globalization and its accompanying byproduct: disinflation/deflation argument.
In any case, the final answer may not be imminent, but it’s coming. The only question is timing and magnitude.

2 Responses to TIMING & MAGNITUDE

  1. franko says:

    I think demographics are beginning to cloud things for policymakers. And while one might expect a wave of retirements to start to gain traction in our society, that will be reduced somewhat by those not prepared for retirement (savings?) or by those who keep working in order to retain medical benefits for a spouse or child….interesting times. And the economy is SO much more global now than it was even 15yrs ago, nevermind 30yrs ago. So historical comparison analysis should be looking for echoes at best.

  2. blut says:

    Very Interesting Blog.
    The odds are at least 85 pct that a recession is in the works, which jives with Roubini.
    I really can’t see any reason that will float it, even short term. I think there are quite a few imbalances that need sorting out. Although those crazy SOB’s in Washington may try to prolong the fiscal bailout but the ship has already taken on a lot water and a rescue may backfire. Ditto for the Fed.
    I guess we’ll see. This has been the most inflationary period of deflation, if we have anymore we might pop !

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