Is U.S. monetary policy still accommodative? It is something that we've probably been taking for granted for several years now. Sure, we often debated whether the Fed was too loose or not loose enough, but we knew the Fed was indeed providing some degree of monetary stimulus with its combination of huge balance sheet and extremely low rates. Now it isn't so obvious.
As I wrote immediately after the Fed meeting last week, the flattening yield curve seems to be saying rates are nearing a peak. In the real economy, the decelerating inflation rate as well as the middling pace of job gains are signs that perhaps policy is a bit tight. The Fed seems hell-bent on hiking rates at least one more time in 2017, as well as starting to reduce the size of its balance sheet. If policy is already too tight, this is a mistake with potentially disastrous consequences. Today we'll walk through the classic signs that monetary policy is tight or loose, and see what that tells us.
The classic transmission mechanism for monetary policy is that low interest rates encourage people to spend more and save less. The idea is that if interest rates are really high, you are enticed to save your money, earn the interest, and spend it at some point in the future. Whereas if rates are low, you aren't getting much for saving, so you may as well spend. It could be that the Fed has already risen rates to a point where people want to save more.
Looking at figures like personal savings as a percentage of disposable income doesn't tell much of a story. For much of 2015-2016, this measure was running at around 6%. The most recent estimate was 5.3%. That could be a sign of a downshift, but could just as easily be noise. I note that in 2005-2006, this figure was down into the 3-4% area, so it could certainly drop further. It also isn't obvious that consumers are borrowing at a faster pace. Total consumer credit grew 5.8% over the last year vs. 6.0% the prior five years. I think there are signs that lending standards are getting looser, but not enough that debt has started growing a lot faster.
Another way that interest rates that are "too low" can show up is if companies are levering up, buying questionable assets based on IRRs that look good only because interest rates are so low. It does appear this is happening to some extent. According to Morgan Stanley, investment-grade companies have near record gross leverage (i.e., Debt/EBITDA) at 2.4x. High-yield companies are at 4.5x, also basically an all-time high. Important to note that this is rising because of the accumulation of debt (i.e., the numerator). The other times where gross leverage has been this high were recessions, i.e., where EBITDA was falling. The fact that debt levels are getting this high now leaves us with little room for error when a recession does come.
It is still the case that capital expenditures are very low, so most of this increased debt has been returned to shareholders, either in the form of M&A or stock buybacks. This makes for a mixed conclusion. The increase in debt suggests that companies find borrowing cheap, i.e., interest rates are low. On the other hand, they can't find anything to do with the money other than buy market share or just give the money back to shareholders. So money is easy, but demand isn't particularly strong.
Yield Curve Slope
Much virtual ink has been spilled over the substantial flattening of the yield curve going on right now. In this case, flattening means that the gap between shorter-term bonds and longer-term bonds is narrowing. Some claim this is a sign that the economy is slowing, since it has been classically true that the yield curve gets very flat just before recessions. However, we should be careful about the causal effect. We can think of the rate on any bond as the market's best estimate of the forward path of overnight interest rates. i.e., the 10-year Treasury yield should be pretty close to what the market thinks the average fed funds rate will be over the next ten years. Hence it makes sense that the current state of Fed policy influences say, two-year notes much more than 10-year notes.
Think about it this way: we know what the Fed's target is right now, and we kind of know where they will be between now and September (unlikely to hike). We even have a pretty good idea between now and December (maybe one more hike, but maybe not). That six-month period is 25% of the time the current two-year Treasury will be outstanding. But it is only 5% of the time that the 10-year will be outstanding. So the current state of affairs is only mildly influential on the 10-year, but highly influential on the two-year.
Once you think about it that way, it becomes obvious that the yield curve should almost always flatten as the Fed is hiking. If current Fed policy is more influential on shorter bonds than longer bonds, it makes sense that during a hiking cycle shorter bonds will rise more than longer bonds. There isn't anything spooky going on. It is simple arithmetic.
Rather than think of a flat curve has a harbinger of doom, think of it as a gauge for how far away the Fed is from completing the hiking cycle. The fed funds rate is currently around 1.16%. The two-year is 1.35%. This suggests the market thinks there is one more rate hike coming. But the five-year is at 1.77%, which suggests the market doesn't think rate cuts are likely in the coming years.
To me this suggests that interest rate policy is very close to neutral right now.
The trade-weighted dollar is about 5.3% off its recent highs, but remains well within the range that has persistent since mid-2015. I think this has much more to do with Europe reflating a bit plus political woes, rather than anything to do with Fed policy.
Financial Market Valuation
The curve slope and USD elements are classic signs of how loose/tight policy is precisely because classically loose policy caused consumer inflation. If anything, inflation seems to be slowing, which many are taking as prima facie evidence that the Fed is already too tight. That's possible. But I think it is equally possible that easy money is flowing disproportionately into financial markets, boosting valuations but having no effect on real economic activity. Consider the business borrowing point above. If companies are using easy money to buy back shares or make acquisitions, that would cause P/E ratios to rise, but not really have an effect on the real economy.
So, what should the Fed do about this? I'd like to see them raise at least a few more times. I don't think easy money has much benefit when we're already at full employment, and by pumping up markets the Fed is courting bubble risks. The next few months will be telling on this front. If inflation stays this low, will the Fed eschew hiking again in 2017? And if so, what happens to P/E ratios and credit spreads? Or conversely, if the Fed hikes anyway, what does that do to risk markets?
The downside risks in markets right now are very real. If the Fed keeps hiking, it will damage valuations, economic growth or both. If the Fed stops hiking, it might buoy valuations for a period of time, but it probably means the economy is already slowing. Trade with caution.
This commentary originally appeared on Real Money Pro at 11:30 on June 21. Click here to learn about this dynamic market information service for active traders.