Albert Edwards: Fed to blow up world at 1% interest rate

Albert Edwards with an entertaining read. I don’t know where the US terminal rate level is, other than it is much lower than markets think.

Moreover, if the SocGen estimate of real monetary tightening via QT is accurate then the question arises how can monetary conditions tighten enough so quickly to spook the Fed into stopping. Put another way, what will be the major transmission mechanism into the real economy to spook the Fed so fast?

My answer is the stock market. 

The prospect of the Fed engaging in rapid balance sheet shrinkage (QT) has spooked the markets. But how do you combine the impact of QT with the Fed Fund hikes to get a handle on where Fed Funds might peak? We think we have the answer – or rather my learned colleague Solomon Tadesse has an answer. Against the consensus view, his work back in May 2018 exactly pinpointed the peak in Fed Funds at a lowly 2½%. His analysis for this cycle puts the peak of Fed Funds below 1.0%! That is so far away from the current consensus that it deserves some serious analysis.
 Lael Brainard, generally regarded as the most dovish of all Fed Governors, shocked the markets on Tuesday by suddenly baring some hawkish teeth. She highlighted the likelihood the Fed will undertake a more rapid shrinkage of its balance sheet than markets were expecting. Clearly this means monetary policy will be tightened faster than expected, but how much faster? What is the trade-off between QT and higher Fed Funds? Surely the faster the balance sheet is shrunk, the fewer rises will be needed in Fed Funds.
 Let’s wind back to May 2018 when our New York-based Quant guru, Solomon Tadesse, published some excitingwork. Basically, as the Fed eased policy aggressively in the wake of the Global Financial Crisis, the Fed Funds Rate (FFR) declined to zero. Butthe expansion of the Fed’s balance sheet (Quantitative Easing) effectively had the policy impact of driving the FFR below zero. But how can you combine both types of easing into a single ‘true’ measure of Fed Funds?
 Solomon utilized cutting edge academic research to understand the QE/FFR trade-off by in effect ‘melding’ the billions of QE into the Fed Funds rate. Hence for most of the 2009-2013 period, although the headline FFR was at the zero floor, what is termed the ‘Shadow’ FFR had been driven down to the equivalent of minus 3% by the aggressive QE.
 The purpose of Solomon’s May 2018 note was to examine the reverse situation – link. How much monetary tightening in the Shadow FFR would there be as the Fed throttled back on QE (aka tapering), and then as it began to shrink its balance sheet (QT), while at the same time hiking Fed Funds? By looking back at previous tightening cycles Solomon was then able to forecast in May 2018 that the Fed would likely stop raising Fed Funds at 2.5%. That was well against consensus, and as it transpired, I dubbed him forecaster of the decade. But what is he saying now? In a sentence, he is saying the Shadow FFR has already risen by 250bp from minus 5%, and now with accelerated QT the headline FFR will likely top out at (or even below) just 1%.

I don’t intend in this note to go through the mechanics of the construction of the Shadow Fed Funds Rate (FFR). I’m not clever enough for that. What I can easily understand though, even as a ‘bear with very little brain’, is that the pace of QE or QT can be combined with the headline FFR to calculate a Shadow FFR.

Hence combining the expansion of the Fed’s balance sheet from sub-$4 trillion at end 2018 to almost $9 trillion was the equivalent of the FFR falling to minus 5% (charts below)! More recently the Fed ending QE combined with just one ¼% hike in headline FFR means the Shadow FFR has already jumped from minus 5% to minus 2.5% – a 250bp hike (see chart below).

Before I get onto Solomon’s current thoughts I just want to highlight, for those like me with short memories, how when Solomon made his mid-May 2018 call that the FFR would peak at 2½%, the market was looking at something nearer 3% (see chart below). Not much difference you might think, but as the Fed enacted its final hike to 2½% in Dec 2018, expectations of easing were rapidly taking hold as investors realized that the Fed had clearly overdone the tightening cycle.

The US bond rally from mid-Nov 2018 onwards was typical of the situation when yields tend to peak before the last rate hike. Currently the market expects the Fed to tighten rates rapidly and the peak in the FFR to be close to 3½% by March 2023. On that basis, you should wait until the back end of this year before dipping your toe into the bond market. But with inflation considered rampant, many investors believe the headline FFR will peak nearer 4%, despite recession fears mounting – eg Deutsche Bank is the first large broker to forecast a US recession.

If Solomon’s models indicate the Fed will struggle to raise FFR to 1% or above, this is a huge divergence with consensus. You can see clearly in Solomon’s chart below how the recent 250bp Shadow FFR hike compares to the cumulative easing and tightening in previous Fed cycles.

Solomon constructs a Monetary Tightening to Easing ratio (MTE, the ratio of the degree of tightening to the degree of easing in the preceding cycle). The charts below show how the MTE ratio declined in the 1980s as disinflation became the dominant theme. Hence since the mid-1980s the tightening cycle has topped out at around 70% of the previous easing cycle. Shouldn’t though, this ratio now return to 1.5x given CPI inflation has comprehensively overshot? Maybe.

But one key reason why Solomon’s MTE ratio has been lower (at 70%) recently is that tightening cycles have been halted because financial market bubbles, created by excessive Fed easing, then blow up and prevent the Fed from further tightening. And if we take the 70% MTE ratio above, Solomon calculates that the Shadow FFR will likely top out with 550bp of tightening (70% of the 800bp easing). Prior to Lael Brainard’s comments, the remaining 300bp hike in the Shadow FFR was split between a headline FFR rise to only 1½% with the remainder being QT. But with the pace of QT likely accelerated, the actual FFR will struggle to get to 1% before the Fed needs to halt the tightening cycle. That is shocking. (Solomons’ detailed note from March 22 can be found here. He is updating his thinking in a couple of weeks, which we will of course highlight).

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