The US yield curve has continued to flatten and San Francisco Federal Reserve chief John Williams felt the need last week to speak of “the next recession and what we should do to prepare for it.” That might seem odd with US equity markets buoyant and other asset prices extremely well-bid. Or perhaps there is an explanation.
A record-shattering US$450 million was paid last week for a painting by Leonardo da Vinci. While the scarcity value of a da Vinci painting helps explain much of the price, the size of the winning bid is surely also a reflection of how years of global money printing by central banks has fuelled asset price inflation.
Yet, while US$450 million is a lot of money it’s nowhere near US$12.96 trillion. That latter figure represents total aggregate US household debt as of September 30, according to data released by the New York Fed last week. Household debt is now 16.2 per cent above its trough in the second quarter of 2013, the report said.
Indeed, even as he contemplates how to prepare for “the next recession” the Fed’s Williams remains comfortable with the idea that “assuming inflation is running at our goal of 2 per cent in the future, the typical, or normal short-term interest rate would be 2.5 per cent.”
Elsewhere, banks such as Goldman Sachs and JP Morgan are now forecasting four Fed rate increases in 2018 as opposed to the three currently implied in Federal Reserve policymakers’ own projections.
And in its “top trade recommendations” for 2018 published last Thursday Goldman forecast “that the yield on 10-year US Treasury Notes will head towards 3 per cent next year.” The yield was 2.35 per cent at the end of last week.
In reality, Joe Sixpack may not be able to actually afford much of an increase in his household debt servicing costs. The US savings rate is already down to 3.1 per cent, its lowest level since December 2007. A lot of American households already seem stretched financially, and upward pressure on wages isn’t yet materially evident even if the unemployment rate is low by historical standards.
Either way, one thing’s for certain. “History teaches us that a recession will come at some point,” as Williams said “and prudence demands that we use this time of relative economic calm to plan for the storms ahead.”
Yet the very ideas Williams focuses on only reinforce the fact that the “economic realities for the world’s developed economies have fundamentally changed” in the aftermath of the global financial crisis.
If US interest rates are only 2 or 3 per cent when the next recession hits, the San Francisco Fed Chief argued that “conventional monetary policy will have lost much of its punch.” The Fed, or indeed any other central bank in the same position, would need to apply unconventional monetary policy much sooner than if benchmark rates were significantly higher.
“We won’t be able to cut interest rates by the typical 5 percentage points to stimulate the economy because we’ll quickly hit the zero lower bound,” Williams explained before going on to discuss other potential strategies including forward guidance, negative interest rates and quantitative easing.
And that brings us right back to the US yield curve.
The existing flattening of the US yield curve could reflect an intuitive collective bond market understanding that regardless of the fact that the Fed is raising rates, the US economy cannot afford higher rates at the longer end of the curve when there are, as yet, few signs of untoward upward price pressures but evidence that US households are already wrestling with the existing costs of servicing US$12.96 trillion of household debt.
Meanwhile, generated by the explosion of money-printing in recent years and nourished by the continued existence of relatively low interest rates, asset price inflation can persist and even accelerate in the near term, a process perhaps exemplified by the price paid last week for da Vinci’s Salvator Mundi.
It is likely to end in tears and investors should be wary, but for now Fed rate rises, buoyant equity markets and an eye-popping price for an Old Master can coexist with a flattening US yield curve and policymaker allusions to the need to prepare for a future recession.