I'm Hot on the Economy, Not on Treasury Rates

I'm optimistic on the economy right now, but pessimistic on Treasury rates. Let me explain. Even as the Fed has become more hawkish, markets have become increasingly skeptical about longer-term rates. This reflects a view that it will only take a few rate hikes before economic growth reverses, hence limiting how high we can expect the Fed's targets will go. But the economy right now appears to me stronger than it was in 2018, and it should soon push yields higher than what persisted during that time. Here's my case. Party Like It's 2018 The memory of 2018 is weighing heavily on traders' minds right now. That year the Fed hiked four times, raising Fed funds from 1.50% to 2.50%. By the fourth quarter, markets had already concluded that money was getting tight, with the yield curve having severely flattened and the dollar rallying substantially. And yet after hiking the fourth in December, Fed Chair Jerome Powell indicated that more hikes were coming in 2019. This touched off a violent selloff in risk assets. Eventually Powell came around to the view that perhaps the Fed had tightened too much resulting in rate cuts in 2019. Many are expecting a similar sequence in 2022. The Fed hikes too far and is forced to either halt hiking or even take back some hikes, perhaps amidst a significant stock market selloff. Starting Position Very Different Exactly how easy monetary policy is can be difficult to gauge. But it is pretty clear that policy was already much tighter in 2018 than it is now. At the start of 2018, the Fed had already hiked to 1.50%. At the time inflation was running in the 1.7% area, so on a real basis, Fed funds were close to 0%. Over the course of 2018, the Fed would hike by 100 basis points with little change in longer-term inflation expectations. Today nominal Fed funds is at 0% and inflation expectations are significantly higher. That means that real Fed funds is negative 2% if not lower. Another way to look at this is by using the Goldman Sachs Financial Conditions Index, which attempts to measure whether conditions are tight or loose using a variety of indicators. Lower numbers indicate looser policy and vice-versa. In the first half of 2018, this measure averaged around 99, but started to rise rapidly in 4Q toward 100, indicating that monetary conditions were getting tight. Today this index is at all-time easy levels, hovering in the low 97s. Neither of these two measures are perfect, but both indicate current policy is looser now than during the 2018 market rout. That suggests that if the economy is at least as strong as it was in 2018-2019, the Fed should be able to tighten at least that much before causing the economy to slow. Economy's Stronger, Tighter Than in 2018-2019 By almost every measure, the economy is stronger and tighter than it was in 2018. I picked a few items below to highlight this, focusing on items relevant to consumer spending. (Table1 Sources = Bureau of Economic Analysis, Bureau of Labor Statistics) Unemployment was slightly lower in 2018, but now wage growth is faster and employment demand appears to be far outstripping labor supply. Disposable income is also growing faster today (and for this measure I stripped out government transfers), while spending has recently grown much more quickly. Lastly, inflation is obviously much higher now. One could counterclaim that all of this household strength is merely an artifact of fiscal stimulus. I tried to strip some of that influence out by using six-month annualized numbers for all items marked with an asterisk. But given that the stimulus probably wasn't all spent in a single period, it could be that some residual effect is still here. With each passing month, however, it is getting harder and harder to dismiss household income and spending as just fiscal support. Wage growth alone is fast enough to support consumer spending at current levels. Plenty of Room to Hike As I said above, Powell made an about-face in 2019 and took back three of the 2018 rate hikes, hence fed funds ended up at 1.75% in 2019. Since inflation expectations were also around 1.7%-1.8% at the time, this meant that real Fed funds came in at about 0%. Since inflation expectations are higher now, the Fed would need to hike somewhere between 2.0% and 2.5% to get to a real target rate of 0%. I don't know if a 0% target is the right one. Maybe it should be higher, maybe lower. But it is entirely speculative to assume that the market can't handle a real target this high. Even the oft-cited 2018 period doesn't provide evidence that a 0% real target rate could cause problems. Moreover, I think this shows why interest rate risk is skewed to the upside. If you buy that the economy can handle rates at least as high as persisted in 2019, then the whole yield curve is too rich. The best case scenario is that rates stay around where they are now, while there are plenty of scenarios where yields are a good bit higher. Stocks Could Still Get Spooked Unfortunately, prices may move according to today's narrative before my argument above can be proven out. In other words, if inflation prints remain elevated, and thus the Fed continues its hawkish tone, it might reinforce this 2018-redux narrative and cause some kind of selloff. Certainly markets did not react well to Powell's hawkish Congressional testimony last week. In addition, there is a risk that inflation remains high enough to truly force the Fed's hand, resulting in a much faster pace of tightening at some point. If the Fed were to hike two to three times in calendar 2022 but core personal consumption expenditure inflation was still well above 3%, the Fed would have to get more aggressive. Markets, rightfully, would be very worried about that outcome, as a rapid hiking cycle would certainly risk a recession. This outcome wouldn't be my base case, but it is a possibility we should respect.

I'm Hot on the Economy, Not on Treasury Rates

The economy right now appears stronger than it was 2018, and therefore should soon push yields higher than what persisted back then. Here's my case.

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