When I’m asked what unnerves me most, it is the front end of the Treasury yield curve, which has shot up dramatically in the past year as markets have re-appraised their view of the U.S. Federal Reserve under Jerome Powell. The flattening of the curve (when short-term yields rise faster than long-term bond yields) has been dramatic. That is all you need to forecast slower growth ahead, which is a challenge for equity valuations still discounting double-digit earnings gains.
With potential U.S. GDP growth stuck around 2 per cent and the fiscal juice – both U.S. tax cuts and rampant growth in government spending – triggering a near-term boost in aggregate demand toward 3 per cent, there is no way the Fed cannot respond to the heightened inflation risks. All the more so with the output gap closed, so evident in the fact that there are now more jobs available than there are people actively engaged in a job search. Wage growth already is picking up steam, and the laws of supply and demand will ensure this continues. The United States has hit such a wall in terms of the pool of available labour that all the gains in net new hirings in the past three months have come from those who have no postsecondary education or are high-school dropouts.
Not just that, but starting wages are on the rise, too. That 0.4-per-cent wage hike we saw in the payroll report for August was likely no flash-in-the-pan. The United States may not end up in recession, even if the Fed has created 10 of them out of its 13 rate-hiking cycles dating back to the end of the Second World War. But there has never been a Fed hiking cycle that failed to expose, and then expunge, what it engineered during the prior period of extreme policy accommodation.
It used to be the economy and classic business cycle that drove asset markets, today it is asset markets that drive the economy. The situation has been turned on its head since the era of Alan Greenspan; the former Fed chief never changed policy without both eyes on the stock market. But now we have a new sheriff in town who seems to understand that it is unhealthy to run things with an eye toward creating asset price bubbles to generate economic growth, then to be forced to ease monetary policy in radical fashion, and then to clean things up as that bubble bursts – to only then create yet another mania in the process.
The combination of fiscal stimulus and tariff hikes at a time when the economy is past the point of full employment, and at a time when the Fed has been pinning the funds rate negative in real terms, carries with it some very important cyclical inflation risks that are not priced in but will likely force the central bank into even more forceful action. As it stands, just getting to a neutral stance – a Fed funds rate that would be neither stimulative nor restrictive – means another 100 basis points (a basis point is defined as a hundredth of a percentage point) on the funds rate, and not once in the past has the Fed ever just stopped at neutral.
Albert Einstein once referred to the power of interest rates as being the eighth wonder of the world.
Well, this is why, beneath the veneer, this has been a much more difficult year for emerging markets, commodities, resource-based currencies and the cryptocurrency space. It is why the median S&P 500 sector is only up a Treasury-bill-like 2 per cent this year; why the equity index – stripping out FAANG (Facebook, Amazon, Apple, Netflix and Google) and Microsoft stocks – is only up 3 per cent; and why it is that the global stock market outside the United States is still in correction phase, down 15 per cent from the January highs.
David Rosenberg is chief economist with Gluskin Sheff + Associates Inc. and author of the daily economic newsletter Breakfast with Dave.
David Rosenberg