Fed Watch: Time to Think About The Other Side?

Tim Duy looks for signs that the bottom of the cycle is approaching:

Time to Think About The Other Side?, by Tim Duy: It is easy to fall into “the world is ending” trap.  But economic downturns do not last forever, and the current episode is no exception. Ever since last summer, the yield curve, particularly the 10-2 steepness, has been sending a signal that I find difficult to ignore – a signal that the technical recession will be rather shallow and short-lived. Indeed, the 10-2 spread currently is consistent with the end rather than the beginning of a downturn:

Yield Spread: 10 Year and 2 Year Treasury Bonds
Basis Points, NBER Recessions in gray

Converted this into recession probabilities, the spread predicts improving conditions throughout the year and into 2009:

Recession Probabilities
12-month ahead forecast, NBER Recessions in gray

Where can one find news to support the 10-2 yield spread story?  One hint comes from Calculated Risk, who notes:

This graph indicates the difference between single family starts and new home sales has narrowed recently, possibly indicating: 1) that fewer homes are being built by owners, and 2) that single family starts are now low enough to begin to reduce the inventory of new homes for sales.

The second point caught my eye, especially after seeing that housing starts are approaching their historical lows. Granted, theoretically they could fall to zero, but that’s not exactly a realistic expectation. Housing starts will eventually bottom, and with starts approaching a level that realistically allows for inventory reduction, it is not unreasonable to expect the bottom to come sooner than later. Even arch-bear Nouriel Roubini envisions a time when housing starts will bottom.  From the WSJ:

New York University economist Nouriel Roubini expects housing starts to drop to at least 700,000 before hitting bottom, with home prices falling through at least 2009. "We're still in the first few innings" of a recession, said the chairman of research firm Roubini Global Economics.

Given that in March 2008, housing starts stood at 947k, down from a cycle peak of 2.3 million units, we probably aren’t more than a few months away from the bottom, even assuming a worst case Roubini scenario.  Reaching a bottom is important in that new residential construction would no longer be a drag on GDP growth; do not underestimate the impact of a flip from subtracting 1+ percentage point of growth each quarter to a flat contribution. Aside from the consumer, incoming data is consistent with an economy scraping along the bottom - Jim Hamilton offers this forecast:

If we eke out a barely positive growth rate for real GDP for 2008:Q1, that along with the anemic 2007:Q4 performance and a sharp drop in 2008:Q2 would probably qualify as a recession.

Hamilton’s forecast of Q1 appears reasonable, but I suspect the expectation of a sharp drop in Q2 is overly pessimistic given that the consumer data should pop temporarily as the tax rebate checks roll in, even if only half those dollars are spent. Also consistent with the borderline recession story are the ISM manufacturing and non-manufacturing indexes:

ISM - Index of Manufacturing Activity
Index, above 50 reflects increasing activity

ISM - Index of Non-Manufacturing Activity
Index, above 50 reflects increasing activity

Just to be clear, while the technical recession may be relatively short lived, I am not optimistic about the other side of this downturn – no V-shaped recovery is in my forecast. Instead, I look for something between the U and the L shapes.  My baseline scenario is that housing starts move sideways after bottoming, neither contributing nor subtracting from GDP.  The housing sector will likely remain in disarray until prices contract to their historical relationship with incomes.  Assuming the mortgage industry returns to historical underwriting conditions, the capital simply will not be available to support prices higher than roughly 3 times local median incomes.  I have trouble seeing a way around such a constraint short of continued, substantial taxpayer support that would effectively amount to a policy decision that the average household should be expected to devote 40-50% of its income to housing costs. I really cannot see this as a socially optimal outcome, and I expect that it would be met with a backlash sooner than later.

Similarly, I expect the job market to remain challenged; recall the period of soft job growth though 2004 following after the technical end of the previous recession:

Non-Farm Payroll Growth
Thousands of employees, monthly change

I anticipate the current cycle to be similar. Jobs will continue to be shed in the housing sector as capacity falls in line with a reduced demand. Moreover, these displaced workers will not easily regain employment in expanding sectors such as health care or export industries.  Soft job growth and declining access to credit via home equity should keep a lid on consumer spending growth, similar again to the post-2001period:

Real Consumption and Confidence
Spending percentage change Y-o-Y (Red), left
Consumer confidence (Blue) , right

So how does one reconcile the so-so ISM data with the consumer data, the latter of which is more clearly dire? Again, I believe the data reflects an adjustment away from a growth path that depends upon the external imbalance. A portion of the consumer slowdown will be off-shored to foreign producers, and exporters (primarily manufacturers) will benefit from the weaker Dollar.  The consequence should be a relatively muted downturn and an expected improvement in the current account deficit:

US Current Account Deficit
Percentage of gross domestic product

The adjustment should yield stark disparities in rates of economic activity across sectors, and this appears to be revealed by the first wave of earnings reports.  From the WSJ:

As first-quarter corporate earnings reports begin to roll in, a stark picture is emerging of an economy on two tracks.

Banks and companies that sell directly to consumers are grappling with the impact of falling home prices and tightening credit. But many big businesses, especially those that sell to other U.S. companies or to customers abroad, are proving resilient.

Best that this adjustment occurs slowly, considering the enormous pressure on the consumer already evident from the gradual improvements to date. Of course, the slower the pace of the adjustment, the longer as well (again, somewhere between the U and L-shapes), and therein lays the danger for policy. Policymakers will be hard pressed to allow the process continue unabated, as they lack the courage to tell Americans that the country needs to learn to live within its means. Given a growing populist sentiment on the back of stagnating median incomes, I see little but a river of red ink from the Federal government.

Monetary policy should be more circumspect, and financial markets are greenlighting the Fed for an end in the easing cycle at 2% despite tame core-CPI data in February and March. From Across the Curve:

Some participants with whom I converse are troubled by the spectre of inflation. While the report issued today was not ugly ,the surge in commodity prices and agricultural prices reminds investors that there will be no inflation relief in the near term. The best bet is that the headline number will only worsen as we go forward. So some traders think that the process has begun by which the market adjusts to the Federal Reserve signalling that the ease cycle is over or is nearly done. That would not bode well for the 2 year note and would precipitate higher yields in that sector.

I would argue that monetary policy is already too accommodative given that the fear of deflation appears misplaced. From Philadelphia Fed President Charles Plosser:

Taking expected inflation into account, the level of the federal funds rate in real terms — what economists call the real rate of interest — is now negative. The last time the level of real interest rates was this low was in 2003-2004. But that was a different time with a different concern — deflation — and monetary policy was intentionally seeking to prevent prices from falling. Recently, we have had reason to be worried about rising inflation, not declining prices. Thus, comparing the nominal funds rate today with the stance of policy in 2003–2004 is like comparing apples and oranges.

Normally, I would not give much credence to Plosser; he has been out of step with the FOMC through the current cycle.  But in the same speech he emphasizes that monetary policy alone cannot solve the current challenges, a realization also made by Governor Kevin Warsh

Fed policy--both with respect to liquidity tools and monetary policy--is partially offsetting the consequences of the liquidity and credit pullback on real activity. But we must be careful to not ask policy to do more than it is rightly capable of accomplishing. The problems afflicting our financial markets are indeed long-in-the-making. Correspondingly, the curative process is unlikely to be swift or smooth. Time is an oft-forgotten, yet equally essential, tool of our policy response.

Warsh also acknowledges the impact of surging commodity prices on inflation:

Consistent with our dual mandate of promoting maximum employment and stable prices, we also need to be alert to risks to price stability. Increases in food and energy prices have pushed up overall consumer prices and are putting upward pressure on core inflation and inflation expectations. We will continue to monitor the inflation situation closely. And, more broadly, in my view, as financial intermediation channels reset, monetary policy will become still more efficacious.

Even arch-dove San Francisco Fed President Janet Yellen cannot ignore the impact of inflation:

The factors weighing down consumer spending go beyond the effects of the credit crunch and the falling house prices. Consumers also face constraints due to the declines in the stock market, which have diminished their wealth. Furthermore, energy, food, and other commodity prices have risen sharply in recent years, essentially “taxing” their incomes. Finally, and very importantly, labor markets have weakened.

The recent wave of commodity price increases I think was undoubtedly exacerbated by the Fed policy of recent months – it takes a leap of faith to ignore the run that was ignited when the Fed cut the discount rate last August.  My concern is that we have now passed the point of no return; even if the Fed stops cutting rates, the expectation of stronger growth will drive further gains in commodity prices.  From Bloomberg:

Crude oil and gasoline climbed to records in New York as better-than-expected earnings results signaled a strengthening economy that may boost demand.

U.S. stocks rallied, capping the best week since February for the Standard & Poor's 500 Index, following earnings reports from companies such as Google Inc. and Caterpillar Inc. that exceeded analyst estimates. Refineries operated at 81.4 percent of capacity last week, the Energy Department reported.

''The real gloomy scenario has been sort of ameliorated with some of these very positive earnings and the indication that the worst is behind us,'' said John Kilduff, vice president of risk management at MF Global Ltd. in New York. ''There will be an uptick in energy demand with the renewed economic outlook for the second half of the year in particular.''

I tend to agree with George Soros; we are still in the early stages of the commodity price boom, and that boom will not come to a conclusion until the inflation outlook is uncomfortable enough that the Fed reverses policy. In the near term, that looks very unlikely.  The Fed is still counting on weak job growth to keep core prices under control, but that is an increasingly fragile forecast.  From the most recent Beige Book:

Business contacts across all Districts continued to report increases in input costs and output prices. In particular, price increases were consistently reported for food products, fuel and energy products, and many raw materials. More specifically, increases in the price of chemicals, metals, plastics and other petroleum-based products were commonly cited. Most manufacturers have or are planning to increase prices in response to rising input costs, while the response of service firms has been more mixed, in part due to differences in competitive pressures. On balance, input costs have risen more rapidly than output prices, putting pressure on margins for many firms. Most Districts reported little change in retail price inflation, though Richmond and San Francisco noted some moderation.

My concern here is that firms will jump at the first chance to drive through price increases, and that chance will be in the next two quarters as the tax rebates provides a boost to consumer spending. If so, the Fed will be well behind the inflation curve.  Although Fed officials believe they can quickly unwind the policy decisions of the last six months, I think it is easier said than done given anticipated weak job growth and still fragile financial markets.

Bottom Line:  I suspect the cessation of rate cuts is near at hand. The Fed will likely pull the trigger on another 25bp at the next FOMC meeting, and send a signal that they intend to pause soon.  I believe they could pause now, but see this as unlikely given their tendency toward dovishness of recent months.  Another 25bp in June is not out of the question, but I think unlikely as well. It will soon be time to turn our attention to timing the next tightening cycle.  Expected job market/housing weakness argues for an extended period of low rates similar to the last cycle; continued strength in commodity prices argues for a more rapid reversal of recent policy.  I believe that a rapid reversal of policy will be politically difficult for the Fed given that Congress will tend toward resisting any protracted structural adjustment that is painful for US households.

Comments

[John Freeland]

What's different about this recession? Expensive energy driven by higher demand, not an interruption in supply. Same with food. People are broke. What's going to change that? More, better jobs and higher incomes? Don't hold your breath, folks.

[David Pearson]

Inflation never looks like a threat when the Fed is cutting. When they signal that they are done, however, it is a different matter. The collective vision of Wall Street looks to a different horizon, one in which the economy is again expanding towards full capacity and in which inflation pressures loom large. The question becomes: how much can the Fed afford to hike if the hikes could arrest the tenuous tendencies towards economic expansion?

What most Fed observers miss is that a "measured pace" rate hike campaign is now out of the question. Inflation expectations are simply changing too quickly for such a dovish strategy. And yet, can one imagine a series of 50bp hikes? Of course not. As Tim Duy points out, the recovery will be too fragile to withstand such force.

So many people believe the commodity bull market will end the minute the Fed stops easing. What they miss is that the Fed's weakness will be evident from the moment of their first rate hike: they are simply powerless to stop inflation without sinking the economy, again, into recession.

[OhNoNotAgain]

I'm not an economist, but it seems to me that we have some severe structural issues with our economy that will prevent us from getting out of this so easily, namely:

- Unaffordable health care costs
- Stagnant or declining real wages
- Rising energy costs

The only one that I see any possible relief for is the health care costs. The other two may see brief periods of respite, but I don't see them going away for any long period of time.

A bottom in housing will be very welcome news, but I'm not looking forward to the next bubble that will be coming down the pike. As far as I can see, until we can do something about shifting back to a more productive economy where the gains are shared more equally among all sectors, we're going to be stuck with bubble after bubble after bubble. We've already seen two in the last 10 years, with the second greater than the first.

[kharris]

I would put a good bit more faith in Duy's views of the Fed and inflation if he ever bothered to discuss special factors that might skew the reading from the yield curve. Faced with an extraordinary disruption to credit markets, one would expect strong demand for the front end. That is likely to steepen the curve, all else equal. I would think that a steep coupon curve at a time in which twos yield something close to the funds rate would have a somewhat different implication than a steep coupon curve when twos have persistently yielded well below fed funds. Duy seems a bit mechanical in relying on a single metric for his read of the economic outlook, the inflation outlook and Fed policy. If it were that easy, everybody would be in on the trick, and we wouldn't need Duy. If all he does is point to the curve, then maybe we don't need Duy in any case.

[Commodities]

GS...`You have a generalized commodity bubble due to commodities having become an asset class that institutions use to an increasing extent,'

GS may have a point. Futures contracts are usually settled in cash, rather than delivery of the underlying commodity. Thus, inventories don't build up. However, contract holders have the option to insist on delivery, which opens up arbitrage possibilities. That is, if the price of the commodity varies significantly from the futures contract, arbitrageurs can buy contracts and insist on delivery. The threat of delivery keeps prices of commodities and contracts more or less even, without inventory build up. The greater the demand for long contracts, the greater the price of contracts/commodities.

Of course, this brings up the possibility of a rule change. When the Hunt brothers drove up the price of silver in the 1980's via contracts, rules were changes. The price of silver fell for 2 decades after that rule change, despite a growing mismatch between mine production and demand.

G.S...`On top of that you have specific factors that create the relative shortage of oil and, now, also food.''

This can't be rule changed away. More resources will have to be devoted to commodity production, which leaves fewer resources available to produce other items. The aggregate standard of living will fall, as fewer total goods will be available (as compared to what would have been available in the absence of commodity shortages).

[ndd]

I made a similar case to that Duy is making over at another blog this weekend. The yield curve has been almost infallible for half a century. It inverted in 2007, and has both un-inverted and rates have fallen across the board since then. That is a very powerful signal that the recession is going to end, most likely by election day. Either M1 money supply will increase, or CPI will decrease, or both, at or about that time, if the past pattern holds true.

In addition to Duy's data, note that the stock market has been moving basically sideways, not down, for the last 3 months, and durable goods and new factory orders are positive YoY.

As John Freeland noted in the very first comment, the argument against this is "Peak Oil!" I tend to think that either the yield curve or "Peak Oil!" will be proven wrong (for the short term) by the end of this year. In this regard I find Chinese efforts to deal with their inflationary boom, and the crash of the Shanghai stock market, not insignificant.

[Storage of Deferred Consumption]

"...decision that the average household should be expected to devote 40-50% of its income to housing costs..."

I wouldn't be to quick to dismiss this. The multiples have been slowly expanding since the high inflation 1970s. The rate of the recent expansion is unprecedented, but not the expansion itself. The 27% with no mortgages may not want a bailout that doesn't give them something also, but they do want their homes to sell for more. 2/3 of Americans are homeowners, and most of them consider their homes to be the only safe inflation resistant storage medium for long term deferred consumption.

Unfortunately, use of homes for this purpose requires that each succeeding generation devote an ever growing percentage of their income to buy the previous generations' homes. Thus, each succeeding generation has a lower standard of living, and works more overtime. It also means a complete mismatch between domestic supply of savings (in a form that can be loaned out, homes cannot be loaned out), and demand for credit. No domestic savings necessarily means import of foreign capital, even if future loans must be insured to attract foreign capital.

What a tangled web was woven when negative real rates prevented people from using dollar denominated debt instruments as a safe, long term store of deferred consumption.

[Yield Curve]

In the past the yield curve had a high correlation with subsequent economic performance, but the relationship is less now (but still exists). The explanation is that in the past, regulated bank lending played a much greater role in funding business, but nowadays business have a much wider range of options for funding.

[Median]

"...stagnating median incomes..."

The question becomes, where is our production going? In aggregate, we are consuming what we make, and supplementing domestic production with borrowed foreign production. Yet median wages buy less. The upper class has gained, but not enough to account for the difference.

Can wage earners/retirees consume the same goods that borrowers (loans financed partly by monetary expansion) have already consumed?

[hari]

There is a lot of policy focused action going on among CBs which we don't get to read about much - after the G-7 meeting and IMF/IBRD session in washington. Don't be surprised BB is finally on same page with Trichet - recognizing the impact of inflation and scarcity of commdity markets and spiralling unti prices.

[hari]

There is a lot of policy focused action going on among CBs which we don't get to read about much - after the G-7 meeting and IMF/IBRD session in washington. Don't be surprised BB is finally on same page with Trichet - recognizing the impact of inflation and scarcity of commodity markets and spiralling unit prices.

[Sunlight]

Tim, if the purpose of the fed rate cuts was to increase bank earnings that would offset bank asset writeoffs, you also need to look at bank earnings reports before making your case. Just this week Citigroup took another $15 billion writedown, Washington Mutual was forced to raise $6 billion on highly dilutive terms, and National City Corp. is also close to a forced capital raise. Right now he fed is driven by a desire to keep the banking system solvent, not by either part of its dual mandate. You may be correct about what you say, but you are looking in the wrong place if you want to predict the Fed's next move.

I would also add: fear of counterparty insolvency seems to be driving the upward moves in short term spreads. I don't know any of my colleagues in the ranks of ull-time financial traders, who actually expect the fed to raise rates.

[Lafayette]

DP: So many people believe the commodity bull market will end the minute the Fed stops easing.

This assumes that i-rates are the sole influence on commodity prices.

But, there's a new player in the game. A 3-billion people economy that is purchasing minerals, oil, cereals and beef in humongous quantities heretofore unseen. That growing demand will maintain a constant upward pressure on commodity prices.

Remember, China has a large land mass, but not all that much cultivatable land. Food has always been its Achilles Heel. No amount of Chinese investment will solve that particular commodity pricing. Ditto oil and and to a lesser extent minerals.

[gw1234567]

There is no silver bullet to get us out of this recession (I think Depression). All the government numbers are cooked and not telling the real magnitude of the problem. They could raise taxes to 100% and cut 100% of every Federally funded program and we still couldn't pay the down the federal debt. If you think the only federal debt is what the government tells it is then you need to add in the unfunded mandates and federal obligations (like social security). The fact is the U.S. is flat out broke and there is no way out. The reason we are in this economic mess is because the chickens are coming home to roost. We have had 10-15 years of slight benefit from globalization, but now the ugly side of it come back to bite in the butt.