Why advisers and clients must keep an eye on the Federal Reserve
“The most expensive words in the English language are ‘this time it’s different.’”
This pithy assertion from legendary investor Sir John Templeton has stood the test of time for a reason, so it is with a shiver that this column sees no less an institution than the US Federal Reserve arguing that the traditional measure of the yield curve should be ignored and a new one considered.
Instead of looking at the premium yield offered by ten-year Treasuries (US Government bonds) over two-year paper, the Fed is now saying we should look at the gap between the six-quarter forward rate for three-month Treasuries and three-month Treasuries themselves.
The US yield curve is flattening as the premium yield offered by ten-year Government bonds over two-year ones keeps shrinking
Source: Thomson Reuters Datastream
One possible explanation for this fudge is that the traditional yield curve is flagging danger. The new one is not.
The premium yield offered by 10-year Treasuries is just 0.22% (down to a 2007 low) and close to inverting, when the two-year yield is higher. While there have been false signals, an inverted yield curve generally warns of economic and financial market trouble ahead and as we negotiate the tenth anniversary of the collapse of Lehman Brothers with markets at new all-time highs, it may be worth considering what could – eventually – end the multi-year bull market in most asset classes that you can think of.
Wages versus wealth
In some ways, we are overdue a correction of magnitude and this can be seen in how growth in US household income, in real terms, has been massively outstripped by growth in US household net worth.
The median US househould income, in real terms, has just got back to the levels seen in 1999 and 2007 at around the $61,000 mark.
US household income has finally reached prior peak levels
Source: US Census Bureau; FRED - St. Louis Federal Reserve database
But US household net worth has just crossed the $100 trillion mark for the first time ever, a mark 50% higher than at the cyclical high of a decade ago.
Growth in US household net worth has outstripped wage (and GDP) growth
Source: FRED -St. Louis Federal Reserve database
The difference is likely to be accounted for by the surge in the value of financial and other assets – equities, bonds, property and frankly everything from vintage cars to art to wine to baseball cards – and this is one warning that at some stage another collapse in financial markets will sweep around the globe.
But surely household net worth cannot sustainably grow this much faster than incomes (or for that matter US GDP which is 17% higher than it was in Q3 2007, in real terms)?
The combination of zero-interest-rate policies (ZIRP) and Quantitative Easing (QE) in the West has contributed substantially to asset price inflation, as advisers and clients have looked for options other than cash in an attempt to generate a return on their money (and protect it from inflation).
Assets have been bid up (and up) and at some stage there has to be a chance that they correct, just as happened in 2000 and 2007, the last occasions when growth in household net worth had outpaced growth in both GDP and household net income for several years in a row.
The question then is what could trigger this pull-back? History suggests it will be an unknown unknown, as something sweeps in from left field to light the blue touch paper (such as the collapse in the Floridian property market that tipped an over-indebted financial system over the edge in 2007).
Lofty valuations and increased debt are both classic preconditions for any financial market calamity and they are in place, judging by the US household net worth figures and figures from the Institute of International Finance which show that global borrowing now massively exceeds the high of 2007.
Global indebtedness is way higher now than in 2007
Source: Bank of International Settlements, Institute of International Finance, Haver Analytics
That means one possible catalyst for disaster is a classic one – a policy error from a central bank and particularly the US Federal Reserve. This is because higher borrowings, and higher exposure of households to financial markets for their wealth, means the impact of any interest rate hikes and drop in securities’ valuations could be magnified.
This puts the Fed in a bind. Inflation is ticking up in the US, and frankly across developed markets (and that’s before asset price inflation is taken into account), so chair Jerome Powell and team will want to nip this in the bud.
Inflation is creeping higher, if only slowly
Source: Thomson Reuters Datastream
The US central bank will also want to normalise policy so it can build up some ammunition for the next downturn. The Fed has cut interest rates by an average of 5.25% since 1970 in response to recessions, once it has embarked upon a down-cycle in borrowing costs. It is hard to cut by that much when the headline Fed Funds rate is 2.00%.
But even a modest – and slow – increase in US borrowing costs, from 0.25% in November 2014, is starting to do damage to financial markets, especially now the US central bank is withdrawing QE (just as the European Central Bank is about to stop adding to it and even the Bank of Japan is being accused of stealth tapering).
Cryptocurrencies blew up first, followed by low-volatility strategies and then emerging markets – the currencies of Argentina, Turkey, Brazil, Indonesia and India, all among the world’s 25 largest economies, are at or near all-time lows against the dollar, which is responding to tighter policy in the USA.
The Fed seems determined to press ahead with rate hikes and the danger is that they overdo it – this is one explanation for why the yield curve is so flat, with US ten-year Treasuries yielding only 0.22% more than two-year paper.
This is because investors believe that while the Fed is keen to drive rates up now it will have to recant and cut sharply later.
That is what the yield curve – the traditional yield curve based on the relationship between two- and ten-year Treasuries – is telling us and that could be why the Fed does not want markets to listen.
Policy error in the Marriner S. Eccles building in Washington therefore remains a key risk, especially as Fed officials are now peddling the line of “it’s different this time.” It is not for nothing that German economist Rudi Dornbusch once noted: ‘No post-war recovery has died in bed of old age – the Federal Reserve has murdered every one of them.’”