The Fed traditionally embarks on an interest rate tightening cycle when inflation
has started to run hot. This decline in the purchasing power of the dollar
will nearly always manifest itself in: above trend nominal GDP, rising long-term
interest rates and a positively sloping yield curve. These prevailing conditions
are all indications of a market that is battling inflation; and thus prompts
the Fed to start playing catch up with the inflation curve.
For example, the last time the Fed began a rate tightening cycle was back
on June 30, 2004, when the Fed moved the Overnight Funds rate from 1% to 1 ¼%.
At the time, the Ten-year Note yield was 4.62%, and the Two-year Note was 2.7%,
creating a 1.92% spread between the Two and the Ten-year Note. To illustrate
the fact that the long end of the yield curve was pricing in future inflation,
the Ten-year yield climbed to 5.14% two years into the Fed's rate hiking cycle.
And perhaps more importantly, real GDP was 3% and rising, while nominal GDP
posted an impressive 6.6% in the second quarter of June 2004.
To reiterate, the last time the Fed began to raise rates it did so on the
back of higher than normal nominal GDP, rising long-term interest rates and
a positively sloping yield curve. With this in mind, let's take a look at the
environment for the current tightening cycle.
The FOMC began its latest rate hiking campaign on December 17, 2015. At that
time, the Ten-year note was 2.24%, and two-year Note was just 1%. Hence, the
2-10 year Note spread was 1.24%. And in the fourth quarter of 2015 nominal
GDP was 2.3%, while real GDP was a paltry 1.4%.
As the markets sit with bated breath for the threatened second rate hike by
the FOMC, the Ten-year Note Yield has actually decreased to 1.72% and the Two-Year
Note dropped to 0.8%, creating a yield spread of a meager 92 basis points.
This is the tightest yield spread since November of 2007. Making matters worse,
nominal GDP during Q1 was 1.4% and Real GDP was 0.8%. Therefore, after just
one measly rate hike from the FOMC, the yield curve is already flattening,
and the rate of economic growth is shrinking.
 |
| Not Your Normal Rate Hike Scenario |
| |
June 2004 |
December 2015 |
Current Data |
| Nominal GDP |
6.6% |
2.3% |
1.4% |
| Real GDP |
3.0% |
1.4% |
0.8% |
| CPI |
3.2% |
0.7% |
1.1% |
| 10 Year Note |
4.62% |
2.24% |
1.72% |
| 2 Year Note |
2.7% |
1.0% |
0.80% |
| Yield Spread |
1.92% |
1.24% |
0.92% |
Pento Portfolio Strategies all rights
reserved
Sources: NY Fed, Treasury.gov, BEA, BLS |
This is in sharp contrast to what occurred in 2004. Back then the bond market
didn't immediately succumb to the Fed's initial raise in rates. The long end
of the curve, as well as inflation, pushed onward despite the Fed's attempts
to slow them both down.
However, the yield curve did eventually invert by 2006 when the Fed Funds
rate climbed to 5.25%. An inverted yield curve forebodes a recession because
the money supply contracts once banks find it unprofitable to make new loans,
and this causes asset bubbles to pop.
If this trend of a rising Fed Funds Rate and falling long-term rates continues,
the yield curve will invert with just a few more interest rate hikes and over
the course of the next few quarters. And this brings us to the most salient
point of this commentary: the major problem is the Fed will most likely have
around 400 basis points less ammo (room to lower interest rates) during this
next economic contraction than it had to pull the economy out of the Great
Recession of 2008.
From September 2007 to December 2008, the Fed reduced rates by 525 basis points
to 0%. However, during this next recession, the Fed will only be able to take
back the handful of 25 basis point increases it managed to push through before
the gravitational forces of deflation plunged the economy into its next collapse.
Indeed, the Fed very well may be filled with such hubris to believe its ZIRP
and QE's have healed the economy to the point that it can normalize interest
rates with impunity. But that is not the message that the bond market or the
economy is telling.
In fact, the FOMC itself will tell you that its desire to raise rates is not
to quell an economy on the verge of bubbling over, but it is instead to stockpile
interest rate ammunition to fight the next recession. Conversely, it will be
these next few hikes that will expedite the economy's cliff dive that will
lead us to a recession worse than 2008.
The sad truth is that it is virtually impossible, after 90 months of ZIRP
and the creation of unprecedented asset bubbles and capital imbalances, for
the Fed to raise rates at just the right pace to maintain a 2% inflation target.
Our central bank will gradually hike rates until the yield curve inverts once
again, and a deflationary depression ensues. Such is the unavoidable consequence
of choosing to abrogate markets in favor of financial despotism.
