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Examining Economic Recovery for Stress Fractures

Examining Economic Recovery for Stress Fractures
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Tuesday, 29 May 2018 08:29 AM Current | Bio | Archive

The U.S. economic expansion is now 107 months old. That makes it the second longest of the previous eight expansions since 1959, when the monthly Index of Coincident Indicators starts (Fig. 1).

This index is highly correlated with real GDP, which is available quarterly (Fig. 2).

The current expansion has lasted this long mostly because it has been relatively slow paced. So far, there hasn’t been a boom, which in the past often set the stage for a bust. It will be the longest expansion if it makes it to July of next year.

However, in recent meetings with our accounts in Texas and North Carolina, I fielded more questions about the economy’s risks of a recession than its potential for record longevity.

Consider the following:

(1) Monetary tightening? Fed officials continue to characterize the tapering of the Fed’s balance sheet and the gradual hiking of the federal funds rate as monetary “normalization.” However, it certainly must seem like monetary tightening to would-be borrowers. Increasing the federal funds rate from zero to 1.50%-1.75% since late 2015 may seem relatively innocuous, but after seven years of rates that were close to zero, from late 2008 through late 2015, it’s a rather big deal. Fed officials have indicated that they intend to continue gradually raising the federal funds rate through next year closer to 2.50%-3.00%, which they deem to be a more normal rate.

(2) Credit crunch? Periods of prolonged easy credit tend to stimulate speculative excesses, especially among borrowers who have relatively short maturity debts that unexpectedly must be refinanced at higher rates. History shows that since the late 1960s, rising rates often have triggered a financial crisis, which turned into a widespread credit crunch and a recession (Fig. 3 and Fig. 4). (For more on this see Chapter 4, “Predicting Business Cycles,” in my new book.)

This time, during the current expansion, lots of money has been raised in the US corporate bond market. From Q4-2008 through Q4-2017, nonfinancial corporate bonds outstanding rose by $2.4 trillion to a record $5.3 trillion (Fig. 5). Might this be the crack in the credit markets that crumbles them? Put another way, might this be the unintended consequence of the Fed’s well-intentioned normalization process?

When I was in Austin, one account expressed concern that lots of “cov-lite” bonds have been issued. He didn’t have any data to back up his concern, and he acknowledged that most of them were issued at historically low rates with relatively long maturities. Furthermore, so far there haven’t been any signs of stress in the yield spread between junk-grade corporate bonds and the 10-year US Treasury bond (Fig. 6).

Admittedly, this credit-quality yield spread tends to be a coincident indicator of the economy rather than a leading one (Fig. 7). It always widens sharply after the onset of a financial crises.

(3) Yield curve inverting? On the other hand, the yield curve spread between the 10-year Treasury bond yield and the federal funds rate is one of the 10 components of the Index of Leading Economic Indicators. Yet it is widely given more weight than any of the other ones—even by Fed officials, as discussed below—because it has a consistent record of inverting just before recessions begin (Fig. 8).

The yield curve spread between the two-year Treasury note yield and the federal funds rate has been relatively tight since the Fed started raising the federal funds rate in late 2015 (Fig. 9). The FOMC has provided lots of forward guidance about the likely path of interest rates, and the two-year has reflected the Fed’s narrative.

The 10-vs-two-year and 30-vs-10-year spreads have narrowed sharply over this same period, raising fears that the yield curve might invert. Melissa and I think the action in the bond market confirms our view that the Fed is ahead of the curve on keeping a lid on inflation. This explains why spreads on the long end of the curve have narrowed, reflecting diminishing long-term inflationary expectations. If the Fed can avert a late-cycle inflationary boom (along with debt-financed speculative excesses), then the expansion could persist for the foreseeable future. In other words, the flattening of the yield curve is bullish, not bearish, for stocks!

(4) Gasoline fumes? Another concern expressed during my meetings in Texas was that the rebound in gasoline prices might depress consumer spending, offsetting the windfall from Trump’s Tax Cuts and Jobs Act (TCJA) enacted at the end of last year. In the past, rising outlays on gasoline caused by spikes in gasoline prices often were followed by economic downturns (Fig. 10). Nominal personal consumption expenditures on gasoline increased $71 billion from a recent low of $225 billion (saar) during February 2016 to $296 billion during March. On a per-household basis over this same period through March, gasoline spending increased by $570 from a recent low of $1,900 (saar) during February 2016 to $2,470 (Fig. 11).

Following President Trump’s decision to pull out of the Iran nuclear deal earlier this month, the Saudis indicated that they are ready to increase their oil production in response to the expected decline in Iranian crude oil bound for international markets. The price of oil tumbled late last week on perceptions that the Saudis were starting to pump more oil. Apparently, Trump made a deal with the Saudis: They will pump more oil if he walks away from Obama’s nuke deal with Iran, reviving sanctions again, including on Iran’s oil exports.

(5) Tax hikes? Many of us who live and work in New York State will be paying more in taxes in 2018 than in 2017 thanks to Trump’s tax-cutting package. That’s because state and local taxes will no longer be deductible, and the deduction for mortgage interest also has been sharply curtailed. The same holds for taxpayers in other states that have relatively high income and property taxes and expensive homes financed with large mortgages. So far, it’s hard to see that the TCJA has boosted consumer spending from the data on retail sales and consumer outlays.

Global Economy: Troubles Brewing? The 2008 financial crisis was global, but its epicenter was the US subprime mortgage market meltdown. There are mounting fears that this time the epicenter might be in emerging markets or European economies. Consider the following:

(1) Emerging markets again? As Melissa and I noted last week, Fed Chairman Jerome Powell discussed the risk that Fed rate hikes pose to emerging markets in a 5/8 speech titled “Monetary Policy Influences on Global Financial Conditions and International Capital Flows.” He reassuringly declared: “There is good reason to think that the normalization of monetary policies in advanced economies should continue to prove manageable for EMEs.” However, he added: “All that said, I do not dismiss the prospective risks emanating from global policy normalization.”

(2) PIIGS again? The 5/25 FT reported: “Mounting fears about political instability in Italy and Spain sent tremors through the eurozone’s two largest peripheral debt markets on Friday with investors dumping the sovereign bonds of both countries and sending European bank shares sharply lower.”

The Italians are struggling, as they do on a regular basis, to form a government. The leaders of the current coalition include so-called “Eurosceptics.” In Spain, the main opposition party called for a vote of no-confidence in the minority rule of Prime Minister Mariano Rajoy, whose center-right Popular party has been hit by a campaign finance scandal.

Let’s not forget about Greece. The Greeks want another round of debt relief from the International Monetary Fund and the Eurozone. Their crisis has been going on since 2010.

(3) Trade war? Fears of a trade war were heightened during February when President Trump slapped tariffs on aluminum and steel imports and more recently threatened to impose significant tariffs on Chinese imports. Along the way, the Trump administration handed out lots of exemptions to companies that rely on aluminum and steel imports. In addition, there may (or may not) be ceasefires already in effect before trade wars have even started, most notably with China, Mexico, and Canada.

Dr. Ed Yardeni is the President of Yardeni Research, Inc., a provider of independent global investment strategy research.

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EdwardYardeni
The current expansion has lasted this long mostly because it has been relatively slow paced. So far, there hasn’t been a boom, which in the past often set the stage for a bust. It will be the longest expansion if it makes it to July of next year.
stress, fractures, economic, recovery
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2018-29-29
Tuesday, 29 May 2018 08:29 AM
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