Will the Fed kill the US economy?Mar 22, 2018

Economic cycles usually end in one of two ways—either a bubble that has been forming in some part of the market pops and takes the economy down with it, or central banks respond to increasing inflation and/or too loose financial conditions with overly aggressive tightening in monetary policy.

We do not see any glaring bubbles ready to burst, although one could contend that the unprecedented central bank liquidity that was poured into markets since the great financial crisis has contributed to a bubble in developed market government bonds. However, we believe the second factor merits more concern—the US Federal Reserve (Fed) being too aggressive during the current tightening cycle, which could short circuit the economic recovery. So what signs should investors look for that might indicate an overzealous Fed pressuring the economy and global risk assets?

Fed funds neutral rate

One popular gauge to consider is the current real Fed funds rate versus the estimate of the neutral rate, also known as r* (the real Fed funds rate which is neither accommodative nor restrictive to economic growth). Based on the chart below, it appears the Fed is fast approaching and even above this neutral rate. However, a few caveats apply. First, the neutral rate changes over time, and the Fed expects it will rise. Second, the neutral rate is an academic estimate that is prone to high uncertainty. Lastly, typically not a lot happens in the economy or with risk assets when the real Fed funds rate initially exceeds the estimate of the neutral rate as there are lags in the transmission of monetary policy.

Financial conditions

Financial conditions indices provide valuable gauges to measure the broader liquidity and monetary support for economic growth. If these indices are tightening too quickly, that may be a sign that monetary policy has been too aggressive. While some of the money market sub-components that measure financial conditions are suggesting some stress and tightening, overall most of these indices indicate we are not yet in the “danger zone” (although peak liquidity is likely behind us). This needs to be watched but is not yet indicating the Fed has gone too far.

The 10-year US Treasury yield

The yield on 10-year US Treasury notes can also be used as a gauge, as asset markets in particular will be more sensitive to a rise in the 10-year yield than the Fed funds rate (though, of course, the two are related). Although the level and speed at which yields are rising are important, maybe even more relevant is why they are rising. Is it because of a stronger economy? Runaway inflation? Higher budget deficits?

While we do not expect runaway inflation, we are concerned that higher budget deficits and trade wars resulting in stagflation could cause yields to shift upwards in an unproductive way. For now, the US economy could support higher 10-year yields if driven by solid economic and corporate fundamentals, which we expect to continue.

Conclusion

If yields rise too quickly for the wrong reasons, such as the Fed being too aggressive in its interest rate hikes or imbalances in the supply and demand for US Treasuries, it could present a challenge to a continued economic expansion and to risk assets. We are likely past peak liquidity support for the US economy, and closer but not quite yet at levels where the Fed’s policy becomes a headwind. Even with the Fed continuing on their tightening cycle, there is some runway before the Fed begins to choke the economy.

Higher yields on the 10-year Treasury could be manageable if they are due to normalizing inflation expectations and stronger growth, as we expect. A moderate risk on positioning within portfolios and an underweight to duration seems prudent in our view.

Michael Greenberg’s comments, opinions and analyses are for informational purposes only and should not be considered individual investment advice or recommendations to invest in any security or to adopt any investment strategy. Because market and economic conditions are subject to rapid change, comments, opinions and analyses are rendered as of the date of the posting and may change without notice. The material is not intended as a complete analysis of every material fact regarding any country, region, market, industry, investment or strategy.