Where Is The Fed's Ammo?

And where are we now? Well we’re at over eight and a half years and counting since the last trough – a lot longer than the average.

At the risk of stating the obvious, economies evolve in cycles (hence, the “economic cycle” and the “business cycle”). If you want a better understanding of why this is the case, then I strongly recommend that you spend thirty minutes watching “How the Economic Machine Works ”, by founder of hedge fund giant Bridgewater Associates Ray Dalio.

I’d go so far as to say it’s compulsory viewing for anyone with more than a passing interest in financial markets. I’ll tag back to Mr. Dalio a bit later.

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When you look at the history of U.S. economic cycles, and where we are now, it’s hardly a contrarian observation to point out that we are closer to the start of the next U.S. recession, than we are to the depths of the last one.

Nobody knows for sure. But it feels a bit like nobody’s really paying much attention to this simple historical fact. Perhaps a large part of this is because it’s taken a full decade for U.S. median real (inflation adjusted) household income to surpass where it was back in 2007.

In other words, the average American family is likely still waiting for a recovery – not battening down the hatches and getting ready for the next downturn.

Central banks and politicians fight economic downturns using an array of tools. And their response is typically proportional to the severity of the recession.

In the Great Recession ending in 2009, we saw a global co-ordinated response unlike any other in history. Interest rates around the world plummeted. In the U.S., the Federal Reserve cut interest rates from over five percent, to zero in the course of just over a year.

Coupled with that, we saw an unprecedented surge of money printing as the Fed expanded its balance sheet (by creating money and buying assets) from a little over US$800 billion to over US$4.4 trillion today, along with a wholesale bailout of the banking system.

The problem is, that ammunition – the five percent of interest rate reduction and trillions of dollars of monetary stimulation – has been spent. It’s taken most of a decade for the Fed to inch interest rates back up to a little over one percent today. And the Fed have only just begun to start the process of unwinding its balance sheet (i.e., letting assets on its books mature and repay principal, and not repurchase more assets).

The Fed knows it’s running low on ammo…

Back in July , I talked about how John C. Williams, the president of the Federal Reserve Bank of San Francisco, had shared a very dim view of the capacity of the Fed to spur much if any more economic growth. He said:

“As a monetary policymaker, I wish I could tell you that it’s within the purview of central banks to solve all this, that the answer lies in raising or lowering interest rates.

Reality, unfortunately, dictates otherwise.

Our long-term challenges are going to require the sort of long-term investments that fiscal policymakers—and private investors—have within their own toolkits: investments in education, job training, infrastructure, research and development… all the things that propel an economy and prosperity over the longer term.”

We have a financial market that is stretched, from a valuation perspective, on all fronts.

The benchmark S&P 500 equity index trades at a forward price-earnings ratio of 19.4 times, above the roughly 18 times multiple we saw at the height of the Global Financial Crisis (GFC).

Ten-year treasuries yield 2.4 percent, just 0.2 percent above their five-year average.

Thirty-year yields at 2.85 percent have back from the three-plus percentage yields we saw in the first quarter of the year.

And what’s particularly of note is the persistent flattening of the U.S. treasury yield curve.

We measure the steepness of the yield curve by subtracting the 10-year (or 30-year) treasury yield from the 2-year (or 10-year) one.

Why is this important? Well, a steep yield curve (where longer-term rates are higher than shorter-term ones) represents a healthy economy. The spread between short and long-term rates represents higher inflation expectations in the future, which is why longer-term investors need a relatively higher return, to compensate them for inflation.

A steep curve also implies a path of rising interest rates, which are usually associated with a strengthening economy. As the economy starts to do well, central banks typically raise rates in response, raising the cost of borrowing and generally keeping economic growth positive but stable, reducing the risk of “overheating”.

A flat or flattening curve implies the opposite. Investors don’t see much more economic growth on the horizon or much in the way of interest rate increases that would accompany it. Likewise, they don’t see much inflation (itself a by-product of a healthily expanding economy).