2017 Review: 

  • 2017 Real GDP – 2.6%
  • Labor market remains strong. The unemployment rate continued its annual descent, dropping another 6/10ths to 4.1%. Nonfarm payroll growth averaged 171k in 2017, another solid year of growth.
  • The 10-Year Treasury had its most range-bound year since 1965. Driving rates were U.S. fiscal policy developments, central bank actions, geopolitical concerns, and decent economic data.
  • The Treasury curve flattened. The 10-Year Treasury was the pivot point of this year’s flattening – the Fed’s persistence in gradual rate increases pushed short yields higher while weak inflation and global yields kept longer yields quiet.
  • The equity bulls enjoyed a big year of returns as hopes of fiscal changes in Washington – primarily deregulation and reform of the tax code – helped send U.S. stocks on a record-setting run in 2017.
  • On a combined basis, the Dow, S&P, and Nasdaq set a total of 205 new record highs in 2017, the most in a calendar year since the Nasdaq’s inception in the early 1970s.
  • Consumer confidence jumped to its highest levels since 2003 with stock prices setting record high after record high, gas prices remaining tame, and unemployment continuing to fall.
  • Perhaps to confident. Consumers tend to run down their savings rate as they become more confident. However, there have historically been points when they have become too confident, often preceding slowdowns. Now looks like one of them.
  • The last time confidence was as high as it is today was 1983, when the economy was growing at over 9%.
  • Homebuilder confidence appeared to be plateauing, before soaring in the final months of 2017 to the highest level since 1999. In fact, every major housing metric improved into year-end.
  • Home prices continued moving higher in 2017 and are now within 1% of matching the previous cycle’s peak.
  • As the Dollar has weakened, it has helped U.S. producers export more goods and services abroad. Trade to the country’s biggest trade partners turned from negative to positive in 2017.
  • The synchronization of global growth is fueling the optimistic outlook and global reflation concerns.
  • The tax reform bill completely overhauled the individual code and created incentives in the corporate code for investment. This should boost growth in the short term but increase the debt long term.
  • As tax reform became increasingly likely to pass, economists revised their growth forecasts higher and higher. However, the boost is expected to be temporary and mild.
  • The Fed surprised markets. As the Fed proved to be more hawkish than expected in 2017 – hiked in March, June, December, began balance sheet roll-off in October, and continued to project 3 hikes in 2018 – short Treasury yields adjusted.
  • The Fed is likely to continue being spurred on by the unemployment rate so long as 1) it remains below their longer-run sustainable rate, and 2) it is not rising.
  • Despite a tightening labor market and improving growth last year, inflation unexpectedly pulled back after nearing the Fed’s 2% target.
  • There appear to be more risks to a modest acceleration in price gains in 2018 than deceleration. Rising commodity prices, possible wage growth, and a weaker Dollar should push prices higher.
  • Inflation has climbed off its 2017 lows, but not by much, and only in the last two months of the year. Market based inflation expectations are rising.

But there are rising risks too:

  • Concern over Inflation is picking up.
  • The Yield Curve is flattening.
  • Optimism, confidence and complacency are reaching nearly unsustainable highs.
  • Asset prices reflect near perfect conditions.
  • Potential for too aggressive Fed.
  • Recalibration of asset prices, credit spreads, cap rates.
  • Suppressed volatility in financial markets.
  • Longer-term obstacles remain – Aging U.S population – Growth of sovereign debt – Weak productivity.
  • Simultaneous shift from global central bankers to less accommodative posture. i.e. Tightening.
  • But the main risk is coordinated Central Bank retreat which will raise the prospect for increased volatility and possible correction in asset prices.
  • Asset purchases by the four major central banks will shrink by more than 70% in 2018 to $50 billion a month from $182 billion in 2017.
  • Currently they are in various stages of beginning the tightening cycle. I can’t emphasize enough, how important that distinction is to understand. This will have big implications for markets, inflation and the outlook for growth.
  • Central Bankers have a poor track record of managing “Soft Landings”

Fed Policy & 2018 Outlook:

This will sound familiar. The Fed is struggling, trying to understand why growth, inflation and productivity are low. The Fed’s preferred measure of inflation, PCE, has been consistently below their 2 percent target over the past five years, and actually fell during 2017. And given this the Fed still raised rates in December. And based on its January FOMC statement, is forecasting three hikes in 2018.

The Fed’s mandate is to pursue full employment and stable prices. And by all accounts, it’s hard to argue that employment has not met their benchmark. But some at the Fed appear eager to hike despite below benchmark inflation. Why?

They are worried about upside risks to inflation arising from a labor market that has already reached full employment and is projected to tighten further. And that an unduly slow pace in removing policy accommodation could result in an overshoot of the inflation objective in the medium term that would likely be costly to reverse or could lead to an intensification of financial stability risks or to other imbalances that might prove difficult to unwind. That said, the justification for tightening is thin. As a result, please pay attention here, the same Fed guidance that has contributed to a significant rise in short term interest rates since September is ultimately likely to result in policy decisions and an economic outcome that drives rates lower.

Here’s how it typically plays out:

  1. The Fed signals a hike, in part because FOMC participants insist low inflation is transitory
  2. Traders take the Fed at its word and sell bonds – yields rise – in part because inflation expectations rise
  3. Sustainable Growth and Inflation fail to materialize
  4. Traders realize they have seen this movie before and buy – long yields fall
  5. The Fed raises rates anyway, in part to counter easing financial conditions
  6. Inflation pressures abate even further due to rate hike
  7. Long yields fall further
  8. The FOMC frets about easier financial conditions again
  9. Return to 1

Got That?

So, why are yields rising? Reread 1 & 2 above, short-term interest rates depend almost entirely on the Fed, or more precisely on expectations for the fed funds rate. The rise in 2-yr note yields from 1.26% to 2.27% since September correlates extremely well with the rise in Fed Funds futures. Long-term yields also depend on the Fed, but the relationship is more complicated. Fed funds expectations matter, but so does the Fed’s tolerance for economic growth and inflation. Since September, the 10-yr note has risen from 2.05% to 2.90%, with most of the rise in 2018.

The top-three things affecting yields now:

  1. The new Fed Chair, Powell, might tolerate faster growth and faster inflation.
  2. The economy is picking up steam.
  3. Prospects for future growth are also improving.

There are other factors, of course, but yields rise when there is reason to believe growth and inflation will be stronger. But they also rise when there is reason to believe they might be stronger. At the moment, there’s a little bit of the former – growth is a little stronger – and a lot of the latter driving yields. Once some of the question marks are resolved, particularly the big three domestic ones, traders will have to decide whether their fears were justified before the direction of the next leg in yields can be resolved.

The economy seems to have accelerated in 2017, primarily thanks to a recovery in the oil and manufacturing sectors. But at a 2.6% real annualized pace in the 4th quarter, hardly roaring. And, inflation is still stubbornly low.

I have been discussing this for years now. Two puzzles must be solved if Fed policy makers are going to hit the right mix now that the economy is at or near full employment. The key to that statement is the right mix of decisions. The Fed can act without resolving the puzzle, and already has, but that doesn’t mean it’s the correct action. The first is the one everyone asks about: What happened to inflation? The second is equally important: What happened to productivity growth? Both have been uncomfortably weak through this business cycle. Accelerating inflation requires one or more of five things:

  1. Stronger demand. People buying more of something.
  2. Stronger overseas demand. Even when demand in the US is stagnant or falling, as it was in 2008, inflation can rise if the rest of the world grows fast enough, as it did in 2008.
  3. An increase in the money supply. If people have more cash to spend and the supply of goods is the same, prices will rise.
  4. Production bottlenecks. A shortage of labor or capital can cause prices to rise as people compete for a short supply of goods. Traditionalists at the Fed, like Yellen, believe this and expectations are the sole causes of inflation.
  5. Out of control inflation expectations. In the US in the Seventies and in Venezuela now, soaring inflation and the expectation it would continue caused people to rush to spend as fast as possible, before money loses value. As a result, demand surges, causing still more inflation. There is no evidence inflation expectations short of hysteria has any inflation impact.

Liftoff Speed

The cure for both low inflation and low productivity is consistent, moderate growth. The economy does not have to boom, but moderate growth alone will not do the trick unless it is sustained. We have had Fed supporting growth for eight years now without creating strong inflation or higher productivity. And now the Fed is removing it’s support.

Consistent and sustained moderate growth is the definition of “Liftoff Speed” which we have been discussing for years. Does the economy have the ability to support the removal of accommodative monetary policy? Apparently, central banks around the world think so. Years of highly stimulative monetary policies by central banks and time have finally overcome various post crisis headwinds. The early stages of global expansion are leading to a shift in monetary policy, toward shrinking rather than growing. Well, central banks don’t describe it as shrinking, their term is “normalization”. Please understand, monetary policy really doesn’t have a “neutral” or “normal” gear. Central banks like to discuss and make policy as if there is a “neutral/normal” zone for policy, because it provides the impression they have control. It’s a passive term that doesn’t imply negative consequences. The Fed has been using this term for decades. But, history does not offer many examples for that. Most of the time, monetary policy is reactionary and therefore either loose or tight relative to economic conditions. When the world’s central banks begin to remove QE, shrink balance sheets, switch to hawkish forward guidance and begin hiking rates; monetary policy is tightening relative to previous policy. It doesn’t matter if its termed normalization.

Currently they are in various stages of beginning the tightening cycle. I can’t emphasize enough, how important that distinction is to understand. This will have big implications for markets, inflation and the outlook for growth. 

So why are Central banks doing this? Ostensibly, because they are forecasting consistent and sustained growth and believe ‘Liftoff Speed’ has been reached.

When the Fed sets interest rates, the traditional approach is to first estimate a “neutral rate” – one consistent with economic activity that neither boosts nor drags on inflation – and set the Fed Funds rate relative to it. This is much, much harder that it sounds, and why the Fed has contributed to 14 of the last 15 recessions. One must be able to accurately model economic activity and how inflation will respond to it. 17 Trillion-dollar economy, piece of cake, right? Globally integrated economies, even easier, right? It would be much easier to set policy relative to current economic activity, but monetary policy works with a lag, and they are concerned inflation will get unanchored from their forecasts like the “stagflation” era of the 70’s and no Fed Chairmen is willing to allow that to happen under their watch. So, to let the economy run a little ‘hot” for a while to regain some of the economic output lost during the past decade is unacceptable. Current classical economic theory requires them to nip inflation in the bud. But inflation doesn’t currently require ‘nipping” as it is still below their 2 percent benchmark. And it really hasn’t been a problem for the past 30 years. Their counterargument is: inflation has been subdued because we have been actively fighting it for 30 years, and we must remain vigilant. I think the most important contributor to low inflation has been globalization, and the Fed can’t do much about that.

If the Fed wants inflation to rise, and based on their 2% benchmark, they do, the rate should be lower than neutral. If they want it to fall, it should be higher. The Fed Models currently estimates the neutral rate is 1.50%. Couple that with inflation stuck below the Fed’s 2% target and there’s no reason to hike.

So, what does all this predict? Three options:

  1. Sustainable growth with an economy able to handle the consequences of a tight job market, economic growth and inflation and still absorb the Fed’s forecast of three hikes resulting in higher yields across the curve – thereby moving from Liftoff Speed to a Soft Landing.
  2. Unsustainable growth with conditions like the past four or five and a Fed remaining gradual and patient continuing to nurse it along.
  3. Unsustainable growth which the Fed misreads as sustainable resulting in premature Fed hikes resulting in a tightening of credit conditions which chokes off the recovery and inverts the yield curve sometime in 2019 – the inevitable exhaustion of the recovery.

We have been in scenario two for most of the post-crisis period. An extended period of global central bank support. Beginning in December 2015, the Fed thought we were moving into scenario one and began tightening rates. But 2016 proved to be unworthy so they returned to scenario two until December 2016 when they began tightening again.  The Fed delivered three rate hikes in 2017, as advertised. In the first half, it was more than the economy could bear. The quarterly tightening pace between December and June was at least partly responsible for 2017’s low inflation. The median FOMC forecast is for three hikes in 2018 as well. The Fed has overestimated growth and inflation risk so frequently in the past ten years. Of course, with the outbreak of global growth, the Fed is convinced it will be different this time. They firmly believe we are now in scenario one.

But I think the same forces which have kept growth and inflation in check will continue to keep them in check now. I think we are in early stages of scenario three right now. And depending on how economic activity develops and the Fed’s response to it we could proceed to the end stages of scenario three or move back to scenario two. It could take longer for traders to figure it out this year than last. Like last year, I expect 10-year yields will rise to their yearly high in the first half before falling back at yearend. As a result, curve flattening is likely to slow until it resumes in the second half. Still, if we are looking at 75bp of Fed hikes and only 10-25bp of increase in long yields, the curve and subsequently credit conditions will have flattened, i.e. tightened, nonetheless. But, we are closer to scenario three than we have been in eight years, and this requires more observation and understanding of monetary policy than any time during this recovery cycle.