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May
03
2023

Fed’s Looking in Wrong Direction
James Rickards

What’s the situation with the economy? The short answer is not good. Here’s why…

There are literally hundreds of economic indicators either as hard data or sentiment surveys released daily. It’s impossible for any analyst to keep up with all of them.

But with computers, natural language processing and charts, it is possible to follow broad trends. The key for any good analyst is to settle on a subset of data that has the greatest predictive power and a long track record of getting things right.

It’s equally important to know whether indicators are leading, concurrent or lagging.

A lagging indicator may be a measure of how bad things are, but it comes too late to do anything to stop the bad turn. By the time you see it, a recession has already begun.

Concurrent indicators are useful as validation of what leading indicators have been saying, but they don’t put you ahead of the curve.

Clearly, the most valuable indicators are leading indicators — signals that arise six months and sometimes a full year before trouble arrives. Those are the ones to watch most carefully if you want to be prepared in advance.

The Fed Lags Behind

For reasons that are not clear, the Federal Reserve is obsessed with lagging indicators. This partly explains why they always get policy wrong. They tighten monetary policy after recessions have already begun, making the recession worse. They ease monetary policy when booms are underway, making asset bubbles bigger.

Just think of the stock market crash of 1929, the Tequila Crisis of 1994, the Russia-LTCM crisis of 1998, the dot-com collapse in 2000 and the mortgage bubble in 2007. You’ll find a poorly timed monetary policy in every instance.

The two biggest failures in the Fed reading of economic signals relate to unemployment and inflation. The Fed considers low unemployment to be a sign of economic strength and a source of inflation.

But unemployment is a lagging indicator. When businesses see declining sales, lower profits and bulging inventories, they will do everything possible to cut costs including canceling new orders, dumping goods, holding sales and closing offices.

It’s only when those measures fail to stop the bleeding that owners begin to fire people. By the time unemployment goes up, the recession has already started.

Don’t Look to Inflation for Answers

Inflation is another misleading signal. It’s meaningful on its own but it has no correlation to the business cycle. In the early 1960s, we had low inflation and strong growth. In the late 1970s, we had high inflation and weak growth. In the late 1990s, we had moderate inflation and strong growth. In the 2010s, we had low inflation and low growth.

Does anyone see a correlation there? There isn’t one. Growth and inflation are empirically uncorrelated. We can agree that inflation is bad (although deflation is just as bad in different ways). But inflation tells us nothing about the prospects for growth.

The idea that low unemployment leads to inflation (which is what links the Fed’s obsessions with unemployment and inflation) is an artifact of the discredited Phillips curve beloved by Bernanke and Yellen and adhered to by Powell on the bad advice of Fed economists.

Why this is so is a debate for another day. For now, it’s enough to know that the Fed clings to two indicators that have no predictive value. They are lagging indicators. This is why Fed policy always lags behind the economy and never leads it.

Look Ahead, Not Behind

Fine. But what are the leading indicators? Where can we look to see what’s coming?

Several powerful leading indicators are hiding in plain sight. They are easy to find and have excellent track records as predictive analytic tools. The problem is that relatively few analysts have heard of them, and even fewer know how to interpret them. Here’s the short list and what they’re telling us right now:

An inverted Treasury yield curve. One type of yield curve is just a graph of yields on like instruments of different maturities. The U.S. Treasury securities market is the largest and most liquid in the world. Treasury securities have almost no credit risk, so the yields reflect the time value of money, inflation expectations, liquidity preferences and not much else.

A normal yield curve is upward sloping, which means that longer maturities carry higher yields. That makes sense. If I’m going to lend you money for 10 years, I probably want a higher interest rate than if I’m going to lend you money for six months.

Right now, the Treasury yield curve is steeply inverted. This means that longer maturities actually have lower yields than shorter maturities.

The 10-year Treasury note yields 3.57%, the 2-year Treasury note yields 4.14%, while the 3-month Treasury bill yields 5.03%. The last time the Treasury yield curve was this inverted was — you guessed it — in mid-2007 and early 2008, just ahead of the global financial crisis.

When investors accept lower yields on longer maturities, it means they expect yields to drop like a rock because of recession or worse. That 4.14% yield on the Treasury note looks weak compared with 5.03% on the 3-month bill.

But the 3-month bill matures in three months. That 4.14% yield on the 2-year will look rich if rates drop to 2.00% by late this year in the depths of a recession. That’s why investors like it. They see the recession coming.

The Eurodollar

An inverted Eurodollar futures curve. This is a bit esoteric, but it’s an even better predictive indicator than the Treasury yield curve. Eurodollar rates are basically short-term interest rates that big banks pay each other for dollars in unregulated markets.

Investors can buy futures contracts on these rates out to five years forward, although the one- to two-year contracts are the most actively traded. Basically, these are long-term bets on short-term rates.

These contracts are priced as a percentage of par or 100.00. The lower the price, the higher the yield (because the discount to 100.00 is greater, so the return is greater). Right now, the June 2023 Eurodollar futures contract is priced at 94.5850. The September contract is 94.9650. The December 2023 contract is priced at 95.3300.

Notice how the price goes up over time? That means markets are betting short-term interest rates are going lower. That’s another recessionary bet. Rates can be expected to come down in a recession, which means those futures contracts could go deep in the money.

This inverted yield curve was also last seen in 2007 and 2008 ahead of the crash.

More Recessionary Omens

Negative Swap Spreads. U.S. Treasury securities dealers buy long-term notes and finance them in overnight repo markets. They receive the fixed rate on the notes and pay the floating overnight rate on the repo.

This same trade can be done in derivative form using an interest rate swap agreement. In the swap, a dealer can receive a fixed rate from the counterparty and pay a floating rate to the same counterparty.

The swap is the same as owning the bond with two differences: There is no bond involved; it’s just a contract. And the parties take credit risk with the counterparty, whereas when you own a Treasury note there’s almost zero credit risk.

It follows that the fixed-rate payment on the swap should be slightly higher than the fixed-rate payment on the actual bond to account for the credit risk in the swap. That’s not the case today. Fixed rates on interest rate swaps are significantly lower than what an investor can receive on the actual Treasury note.

Is this because dealers trust bank credit more than U.S. Treasury credit? Not at all. It’s because the swap does not use up balance sheet capacity, while the actual Treasury note does. It’s also because Treasury notes are in short supply whereas swaps can be written in unlimited quantities.

Both conditions — balance sheet constraints and shortages of Treasury notes — are indicative of ultra-tight monetary conditions that lead to recessions.

There are other technical monetary indicators that point in the same direction. In addition, there’s a flood of hard data from non-monetary channels including declining world trade, declining industrial production, falling house prices, deteriorating consumer credit, declining real wages and many other indicators that all point to a recession.

So the recession is definitely coming and may already be here, according to the best predictive analytic data. The Fed will be the last to know because they’re looking in the rearview mirror at lagging indicators.

Get ready for the recession and don’t expect the Fed to help you see it coming.

James G. Rickards is the editor of Strategic Intelligence. He is an American lawyer, economist, and investment banker with 35 years of experience working in capital markets on Wall Street. He was the principal negotiator of the rescue of Long-Term Capital Management L.P. (LTCM) by the U.S Federal Reserve in 1998. His clients include institutional investors and government directorates. His work is regularly featured in the Financial Times, Evening Standard, New York Times, The Telegraph, and Washington Post, and he is frequently a guest on BBC, RTE Irish National Radio, CNN, NPR, CSPAN, CNBC, Bloomberg, Fox, and The Wall Street Journal. He has contributed as an advisor on capital markets to the U.S. intelligence community, and at the Office of the Secretary of Defense in the Pentagon. Rickards is the author of The New Case for Gold (April 2016), and three New York Times best sellers, The Death of Money (2014), Currency Wars (2011), The Road to Ruin (2016) from Penguin Random House.

 

  

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