Most Disappointing Recession Ever

The financial markets are not happy that the economy is not crashing as they hoped…

Ueda and No Landings

Data this week confirmed both that “disinflation” is not running wild and that the U.S. economy is not falling off a cliff. A comment by a senior German central banker (Isabel Schnabel) summed up the situation (for Europe and the U.S.): “Markets are priced for perfection… They assume inflation is going to come down very quickly toward 2% and it is going to stay there, while the economy will do just fine.”

At 0.5%, January’s CPI increase was the strongest in three months (in line with expectations). But with revisions, year-over-year consumer inflation of 6.4% was higher than the 6.2% expected. In short, pricing pressures remain robust, while hopeful forces of “disinflation” seem to have stalled – especially in goods pricing. Services prices increased 0.6%, Housing 0.8%, Food & Beverages 0.5%, and Transportation 0.4%.

January Producer Price Inflation (PPI) increased 0.7% for the month, higher than the expected 0.4%, and the strongest monthly gain since June (December revised to negative 0.2% from negative 0.5%). PPI excluding food and energy rose a stronger-than-expected 0.5% (expectations 0.3%), while December core was revised to 0.3% from 0.1%. This put year-over-year PPI at 6.0% (expectations 5.4%), with ex-food and energy PPI up 5.4% (expectations 4.9%).

Retail Sales surged a stronger-than-expected 3.0% in January, a remarkable recovery from December’s 1.1% drop. Retail strength was notably broad-based, with robust gains in Vehicle sales (5.9%), Furniture (4.4%), Department Stores (17.5%), Eating & Drinking Establishments (7.2%), and Electronics (3.5%).

The year began with a big cross-market squeeze that spurred surging bond prices/sinking yields. With analysis and punditry following market direction, a narrative soon took hold of recession and impending dovish Fed pivot. “Look at what the market says over what the Fed says.” A look at the markets has been telling: financial conditions have significantly loosened.

I believe the world is transitioning to a new cycle. Expectations that inflation conveniently returns to previous cycle dynamics is wishful thinking. Hopes that central bankers can quickly conclude tightening cycles without the need to inflict pain are unrealistic.

February 16 – Bloomberg (Alex Tanzi): “US household debt soared by the biggest amount in two decades in the fourth quarter, with younger borrowers in particular struggling to make loan payments amid high inflation and interest rates. Households added $394 billion in overall debt, the largest nominal increase in 20 years, bringing the total to a record $16.9 trillion, according to… the Federal Reserve Bank of New York…”

February 16 – Yahoo Finance (Gabriella Cruz-Martinez): “As credit card debt hit an all-time high — just shy of $1 trillion — in the final three months of 2022, delinquencies among borrowers accelerated. Balances grew $61 billion in the fourth quarter from the previous one to $986 billion, the Federal Reserve Bank of New York found. That marked the largest quarterly increase and the highest total since the series began in 1999… The $130 billion year-over-year increase in credit card debt, also the highest annual gain on record per the New York Fed, came as interest rates on credit cards also hit new highs…”

February 15 – New York Times (Jim Tankersley and Alan Rappeport): “The United States is on track to add nearly $19 trillion to its national debt over the next decade, $3 trillion more than previously forecast, as a result of rising costs for interest payments, veterans’ health care, retiree benefits and the military, the Congressional Budget Office said… The new forecasts… project a $1.4 trillion gap this year between what the government spends and what it takes in from tax revenues. Over the next decade, deficits will average $2 trillion annually, as tax receipts fail to keep pace with the rising costs of Social Security and Medicare benefits for retiring baby boomers. To put those numbers in context, the total amount of debt held by the public will equal the total annual output of the U.S. economy in 2024, rising to 118% of the economy by 2033.”

Lost in all the discussion of monetary policy, market forecasts and economic prospects is that Credit continues to expand excessively. Annualizing the New York Fed’s Q4 household borrowing data, Credit card debt expanded at a 26% pace and total debt at a 9.5% rate during the quarter. The big story so far is how little impact the Fed’s aggressive tightening cycle has had on incessantly loose financial conditions. And with inflationary biases percolating throughout the economy (and globally), reining in excessive Credit growth will require tighter financial conditions. In short, the Credit boom must end, and the transition to new Credit dynamics will be anything but pain free.

American households are borrowing more to pay for higher priced goods, food, automobiles, services and such. Our spendthrift government borrows more to pay for rising costs on expenditures, including debt service. Corporations borrow more to finance rising cost structures, along with investment booms directly and indirectly associated with new cycle inflationary pressures (including “de-globalization,” renewable energy and climate change).

Importantly, previous cycle inflationary dynamics – where Credit and liquidity excess would bypass traditional inflationary channels as it gravitated to inflating asset Bubbles – are transitioning. Credit and monetary inflations now bolster consumer and producer price inflation. And unprecedented monetary and fiscal pandemic stimulus not only supercharged spending and inflation dynamics, but also left a residual of huge cash balances (household and corporate). These new cycle dynamics are in the process of creating significant challenges for central bankers and highly speculative financial markets.

February 16 – Bloomberg (Steve Matthews): “Federal Reserve Bank of St. Louis President James Bullard said he would not rule out supporting a half-percentage-point interest-rate hike at the Fed’s March meeting, rather than the quarter point that other officials have signaled may be appropriate. ‘My overall judgment is it will be a long battle against inflation, and we’ll probably have to continue to show inflation-fighting resolve as we go through 2023,’ Bullard told reporters… Bullard also said he advocated for a 50 bps increase at the Fed’s meeting earlier this month, echoing remarks from Cleveland Fed President Loretta Mester earlier in the day…”

The rates market is now pricing peak Fed funds at 5.28% for the July 26th FOMC meeting, 44 bps higher than about two weeks ago (February 2nd). Over this period, rate expectations for the December 16th meeting have surged 45 bps to 5.07%. Two-year yields have jumped from 4.11% to 4.62%. Ten-year Treasury yields are up 42 bps to 3.82%, with benchmark MBS yields surging 69 bps in two weeks to 5.38%.

The Atlanta Fed’s GDPNow model currently forecasts Q1 growth at 2.50%. Already this year, Wall Street’s bullish narrative has morphed from mild recession and Fed dovish pivot, to Goldilocks and “soft landing”, to the more recent iteration, “immaculate disinflation” and “no landing.”

Don’t misconstrue economic resilience for system soundness. Loose conditions are extending the Credit cycle – rather than circumventing it. A serious inflation fight will require higher rates sufficient to restrain Credit growth. And prospects for the downside of this historic Credit cycle are troubling, to say the least. “No landing” exuberance will have a short half-life.

While policy rate expectations have adjusted higher, rate markets still price in a dovish pivot for later in the year. There remains a 39 bps differential between rates at the July 26th (5.28%) and January 31, 2024, (4.89%) FOMC meetings, what I believe is the market discounting probabilities of an “accident” forcing a Fed pivot. Japan is high on the list of accident candidates.

February 16 – Reuters (Leika Kihara and Tetsushi Kajimoto): “For Prime Minister Fumio Kishida, Japan’s next central bank chief had to symbolise a departure from the unconventional policies of his predecessor Shinzo Abe – but without angering pro-growth lawmakers of Abe’s powerful political faction. The tricky task of steering the Bank of Japan (BOJ) out of years of ultra-low interest rates without upending markets required the skill to read markets and clearly communicate policy intentions, both domestically and internationally. Kazuo Ueda, a 71-year-old university professor who has kept a low profile despite strong credentials as a monetary policy expert, ticked some important boxes. He was branded neither an explicit dove nor hawk. While he was not even on the list of dark horse candidates floated by the media, Ueda was well known in global central bank circles.”

February 14 – Bloomberg (Isabel Reynolds): “Japanese Prime Minister Fumio Kishida said it would be important for the Bank of Japan to make appropriate decisions on monetary policy as markets change rapidly, indicating his desire for flexibility under the new governorship. Kishida was responding to questions in a parliamentary committee about his nominee for BOJ governor, Kazuo Ueda, and the future of Japan’s ultra-easy policy, dubbed ‘Abenomics’ after the late former Prime Minister Shinzo Abe. ‘From now on, the situation around the world and in the markets is going to change rapidly,’ Kishida said. ‘In that situation it’s important to make appropriate decisions.’”

Prime Minister Kishida understands that Japan must conclude the “Abenomics” experiment and rein in Kuroda’s runaway monetary inflation. He has called upon widely respected monetary scholar Kazuo Ueda to craft an exit strategy. By all accounts, Ueda is thoughtful, pragmatic and cautious. Expectations are that he will begin implementing a plan for measured normalization at some point this year. The right man and a not unreasonable strategy.

Markets seemed poised to accommodate. Global yields were dropping, the dollar weakening, inflationary pressures abating, and pressure on global central bankers was waning. Importantly, pressure was easing off the yen and government bond market. Time seemed to be on the side of the soon-to-be governor of the Bank of Japan to deliberately craft his course of action. Perhaps some tinkering (scrapping 10-year JGBs for shorter maturities), but abandoning YCC (yield curve control) could wait for another day.

But suddenly, the backdrop has shifted. Global inflation has not morphed into “disinflation;” the Fed and central bankers are not off the hook; bond yields are surging; and dollar strength is reemerging. Japan’s vulnerable currency and bonds are suddenly back in market crosshairs.

I just don’t see Kazuo Ueda as having months to settle in – to build camaraderie with his BOJ colleagues, while establishing credibility with the markets. Trial by fire. “Measured” and “gradualism” seemed foolproof – only a week or two ago. Everyone has a plan until they get punched in the mouth. How will Ueda respond to a sinking yen? To a serious breach of yield curve control?

The problem is that adhering to yield curve control would likely force the BOJ into (many) hundreds of billions of additional debt monetization – liquidity creation that risks dislocation and a crisis of confidence for its fragile currency.

February 14 – Reuters (Jamie McGeever): “The explanation for the whoosh higher in risk assets this year may be as simple as it is surprising: eye-popping liquidity from central banks. Largely thanks to the Bank of Japan hoovering up domestic government bonds to keep its ‘yield curve control’ policy intact, and stimulus from the People’s Bank of China (PBOC), aggregate liquidity from the official sector has surged in recent months. Apollo Global Management’s Torsten Slok reckons the BOJ bought $291 billion of bonds in January – a monthly record which contributed to G4 central banks’ first net injection of liquidity into the global financial system since last April.”

I don’t believe we can at this point overstate the importance of BOJ policy and Japanese liquidity. The weak yen and ongoing negative rates were a boon for global leveraged speculation last year, partially mitigating the forces of de-risking/deleveraging. Over recent months, BOJ monetization has been instrumental in offsetting QT effects from the Fed and others – global liquidity support likely instrumental during the big squeeze and reemergence of “risk on” liquidity abundance.

For the most part, markets remain sanguine. Everything appears steady as she goes. No radical policy shifts by Ueda seem to ensure ongoing BOJ liquidity support, a dynamic that could help explain why rising global yields have thus far not spurred “risk off” deleveraging and tightening liquidity conditions.

I would however caution that the situation is turning tenuous. The clock is now ticking on global “risk on.” So long as financial conditions remain loose, markets will face elevated inflation and policy tightening risks. Moreover, rising yields risk unleashing de-risking/deleveraging dynamics. The weak yen bolsters dollar strength, with rising yields and a resurgent dollar pressuring the emerging markets. “Doom loop” – rising yields and dollar gains forcing EM central banks to liquidate Treasuries and international reserves to support flagging currencies – risks lurk. Meanwhile, a stronger dollar, rising yields and risk aversion would pressure Italian bonds and Europe’s vulnerable periphery, with European bond markets and the euro susceptible to their own “doom loop” dynamic. A resurgent dollar and global “risk off” would also spell trouble for China and the renminbi.

And surging global yields and troubles in EM, Europe and China would compound risks to Japan’s vulnerable bonds and currency. There’s a scenario where Governor Ueda is forced to choose between maintaining yield curve control and stabilizing the yen. Currency stability would take precedence. Yield curve control, after all, is unsustainable anyway. And abandoning YCC with global markets in the throes of de-risking/deleveraging would surely unleash acute instability.

But I’m jumping too far ahead of things. Ueda’s term doesn’t even begin until April. While vulnerable, global financial conditions remain loose. There is yet minimal evidence of the bond market reversal spurring general de-risking/deleveraging. Heck, the stock market took some shots – during options expiration week, no less – and barely flinched.

It wouldn’t be surprising to see equities market game-playing run for a stretch. For 2023, greed shifted decisively to the bull camp and fear to the bears’. So, a highly speculative market will target “weak hands” for short squeezes and bearish option position reversals – until that game quits working. Speculative dynamics bolster the old “climb the wall of worry” dynamic. Especially in the current backdrop, it’s a dangerous game. Greater fool.

But keep your eye on the yen. The Japanese currency traded above 135 to the dollar intraday Friday for the first time since Kuroda loosened YCC on December 20th – and dropped a notable 2.1% for the week. Does yen weakness (dollar strength) exert contagion effects on the euro and EM currencies? And, of course, we’ll monitor global bond markets, expecting rising yields to pressure Japanese bonds.

For now, markets are emboldened that ongoing yield curve control will continue to offer a reliable source of global liquidity. This assurance only heightens the risk of serious dislocation the day the Ueda BOJ ditches YCC. The way things are lining up, I wouldn’t bet on the “no landing” scenario.

Original Post 18 February 2023

TSP Smart & Vanguard Smart Investor serves serious and reluctant investors

Categories: Doug Noland

%d bloggers like this: