Senin, 04 Juni 2012

Why a recession is not likely, and the Fed has no reason to ease further

The world seems obsessed with the idea of a Eurozone collapse sparking a global recession. Capital is fleeing Eurozone banks, and seeking out the safety of the dollar, the yen, and Treasuries. It's difficult to know today what the ultimate outcome of the current Eurozone turmoil will be, and whether and by how much that will impact the U.S. economy. Should the Fed be launching another round of easing to ward off these risks?

A quick look at key market-based indicators of risk suggests that a U.S. recession is not very likely, and that there is little or no need for the Fed to do anything at this point.

10-yr Treasury yields have plunged to an all-time low of 1.5%, but 10-yr TIPS break-even rates show no sign of unusually low inflation expectations, and 5-yr, 5-yr forward inflation expectations derived from TIPS and Treasuries have actually been rising for the past 9 months and currently stand at 2.6%. This suggests that the decline in nominal yields is being driven not by declining inflation expectations—which in turn would be what we might expect if there were a need for the Fed to ease—but by sharply declining expectations for real growth. See my earlier post for more details on this theme.

Foreigners' insatiable demand for safe-haven assets that also offer a guaranteed yield is most likely the driving force behind the unprecedented low in Treasury yields, because it's hard to find evidence that the outlook for the U.S. economy is that dire. Plus, the decline in 10-yr yields began in earnest about the same time that the Eurozone financial crisis began heating up last summer, and 10-yr yields have closely tracked the decline in Eurozone equities.

The strong correlation between European economic conditions and 10-yr Treasury yields can be seen in the above chart (10-yr Treasury yields in white, and the Euro Stoxx equity index in orange). In contrast, U.S. equities have been trending higher for the past two years even as Eurozone equities have moved back to their 2009 lows. Clearly, the Eurozone is the epicenter of the world's growth and financial concerns.

I've shown this chart many times in the past several years, and it continues to be useful, because it strongly suggests that the U.S. economy is not currently at risk of a recession. What it shows is that every recession in the past 50+ years has been preceded by 1) a pronounced rise in the real Federal funds rate, and 2) by a flat or inverted Treasury yield curve. In other words, tight monetary policy has been the proximate cause of every recession in the past 50 years. Currently, we are very far from seeing either of those two conditions prevail, thus the likelihood of a near-term recession is very low.

The logic behind this chart is fairly simple. The blue line represents the real Federal funds rate, which is one of the best ways of determining whether monetary policy is tight or loose—the Fed itself uses this as a gauge of how easy or accommodative policy is. The higher the real funds rate, the tighter monetary policy is, and very tight monetary policy is main tool the Fed uses to slow economic growth and reduce inflation pressures. To judge from this chart, whenever the real funds rate exceeds 3% it's time to start worrying about a recession. Today, however, the real funds rate is -1.6%, and it has rarely been lower.

The red line measures the slope of the Treasury yield curve from 1 to 10 years' maturity, and this is another way of gauging how easy or tight monetary policy is. A steep yield curve is the result of the bond market anticipating a future tightening of monetary policy. The steeper the curve, the more the market expects the Fed to tighten in the future; by the same logic, a very steep yield curve is an indicator that the Fed is very accommodative, and can't remain that accommodative for very long before it will have to start raising rates. A flat or inverted curve, on the other hand, means that the Fed is so tight that the market expects they will have to soon begin easing, because the market senses that the economy is suffering from high real yields and beginning to slow down. Currently, the yield curve is neither extremely steep, nor flat, nor inverted. This further suggests that the Fed is not as easy as the extremely low level of the real funds rate would suggest, but they are still easy.

That is, what has happened over the past year is that the Fed has become "less easy."

Since early last summer, just before the Eurozone crisis started heating up for a second time, the yield curve by this measure has flattened by almost 150 bps; and since mid-March, it has flattened by almost 100 bps, with almost all of the flattening coming from a decline in 10-yr yields. The chart above shows the steepness of the curve in a slightly different perspective, and here it should be obvious that despite the significant recent flattening of the curve, it is still a long way from being flat or inverted. In other words, the Fed is less easy than it was a year ago, but still easy.

We can also see evidence of less-easy monetary policy in the 15% decline in gold prices since last summer, in the 11% rise in the dollar, and in the 16% decline in the CRB Spot Commodity Index. (See the respective charts above.) If the Fed were really tight, commodities would be far lower than they are today; as it is, they are still significantly above the extremely low levels of 2001. Furthermore, the dollar would be much stronger that it is today, since it is still very close to historic lows and far below the highs of early 2002. All of these sensitive indicators of monetary policy have behaved in a manner consistent with monetary policy becoming less easy and dollars becoming less abundant.

2-yr swap spreads (above chart) are a good way of measuring how tight monetary policy is. When policy is very tight, dollars are in short supply and swap spreads tend to rise because systemic risk is rising and the economy is slowing; rising swap spreads are like the canary in the coal mine, warning that dangerous conditions are approaching. Although swap spreads have increased a little of late, they are still within what might be termed the safe zone—nowhere near high enough to indicate a serious problem. Again, this is consistent with monetary policy that has become less easy, but is still far from being too tight.

Credit default swap spreads can sometimes, but not always, be a measure of how tight monetary policy is. If policy is very tight, then dollars become scarce, the economy slows, and deflation risk rises, and all of those conditions increase default risk. In the chart above, we see that default risk has indeed risen of late, and currently is at a level that preceded the last recession. But taken in the context of other indicators which suggest that monetary policy is less easy but still "easy," I think it's safe to say that the cause of the rise in CDS spreads has very little to do with U.S. monetary policy and everything to do with the problems in the Eurozone. The market is legitimately concerned about the risk of Eurozone contagion, but so far there are no signs of recessionary forces building inside the U.S. economy.

How has the Fed become less easy if they haven't announced such a change in policy? That's easy: the Fed has become less easy inadvertently, because they have not responded to an increase in dollar demand from global investors. As a result, dollars have become somewhat less abundant in the past year. Not in short supply, simply less abundant. On the margin, there has been the equivalent of a modest tightening of monetary policy, but not by enough to threaten the economy. This is a very important distinction.

What this means is that the Fed should not feel greatly pressured to implement a third round of quantitative easing. The problems the world is facing are not because the Fed is too tight (like they were in 2008, when they failed to ease in response to a huge increase in the demand for dollar liquidity, which in turn led to a 25% plunge in gold and an unprecedented surge in swap spreads), but because of the trauma facing the Eurozone countries. There is very little the Fed can or should do to address that issue; it's simply not our problem.

This is not to say that there is zero risk of a recession, but rather to say that to date there are very few signs that a U.S. recession is imminent or even likely, and almost no indication that the Fed needs to initiate another round of quantitative easing.

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