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Is the Fed behind the curve? (Part 1)

Is the Fed behind the curve? (Part 1)

Issues to be addressed in this research paper

Is the US economy booming? If so, is the Federal Reserve Bank falling behind the curve? A growing number of economic statistics certainly suggest that the US economy is in better shape than it has been for several years:

(I) Initial jobless claims are now below the numbers last seen in the boom years just before the financial crisis;

(II) wage growth is back to the highs of 2005; and

(III) bank loan growth is rising steadily and is now in line with the levels experienced in the 1980s and 1990s.

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These factors (and more) led to a very robust Q3 (chart 1) and, with Trump about to take charge, US economic growth could possibly accelerate further – at least in the short term. Such acceleration in economic activities could lead to more inflationary pressure and would imply that the Fed has been too hesitant in hiking rates until now.

Chart 1: US GDP Growth Rate
Chart 1: US GDP Growth Rate
Source:, BEA, January 2017

Over the last 40 years, rapid growth in bank lending has been closely associated with rising bond yields. In fact, never have we experienced an increase in bank lending of the proportions we do now without a significant back-up in bond yields (chart 2).

Chart 2: US Bank Loan Growth vs. US 10-Year Treasury Yield, %
Chart 2: US Bank Loan Growth vs. US 10-Year Treasury Yield, %
Source: The MacroStrategy Partnership, September 2016

Since chart 2 was produced last September when 10-year bond yields were hovering around 1.6%, US bond yields have risen. At the time of writing this paper, the yield on 10-year Treasury bonds is 2.39% - down from the mid-December peak of 2.61%. In this paper I will assess whether one can expect US bond yields to rise further – as the Fed looks to correct for their delay in raising rates – or whether the ‘worst’ is over.

The challenge facing Trump

President elect Donald Trump has promised the US populace a return to the ‘good old days’ of at least 3.5% annual GDP growth. We all know that economic growth (∆GDP) at the most fundamental level is a function of two factors only:

(I) ∆GDP = ∆Workforce + ∆Productivity

We also know that the US workforce will only grow modestly over the coming few decades; +0.55-0.60% per annum between now and 2050 to be more precise (Source: Hamam Phanhg, Korea Labour Institute, 2008). This implies that productivity needs to grow by at least 3% per annum for Trump to deliver on his promises. I am conveniently ignoring the fact that cyclical factors can, and will, affect ∆GDP in the short run, e.g. from year to year. Think of the equation in (I) as a proximity that provides the best picture over a full economic cycle.  In other words, it is a very good indication of trend growth.There is only one problem – productivity has never grown that fast. During the best of times it has grown 2-2.5% annually but, at present, productivity growth is actually slightly negative.

As a result, Trump’s only realistic alternative – at least if he wants the faster growth pattern to be more sustainable in nature – will be to increase government spending – the ‘G’ in:

(II) GDP = C + I + G + (X – M)

One could argue that the US could do with more public spending – so dilapidated is their infrastructure – but that is not the point of this research paper. One could also argue – and I tend to agree – that US economic growth will benefit in the short term from the Trump factor, whether he increases public spending or not. Such has been the recent strength in sentiment indicators - consumer sentiment at a 15-year high (chart 3a), and business (CFO) optimism as well as small business optimism now at 12-year highs (chart 3b and chart 3c).

Chart 3a: US Consumer Confidence Index
Chart 3a: US Consumer Confidence Index
Source:The Conference Board, Bloomberg, December 2016
Chart 3b: US CFO Optimism Index
Chart 3b: US CFO Optimism Index
Source:The Daily Shot, Investment Strategy Group, Haver Analytics, September 2016
Chart 3c: US Small Business Optimism Index
Chart 3c: US Small Business Optimism Index
Source:The Daily Shot, Investment Strategy Group, Haver Analytics, September 2016

One of the (many) problems facing Trump – and the Federal Reserve Bank – is that there are significant capacity constraints in many parts of the US economy at present. I have already mentioned that jobless claims are now below the levels we experienced in the boom years just before the financial crisis. Adding to that, the level of unemployment is now 4.7% – below the level most economists consider inflationary (aka NAIRU which is widely considered to be around 5%) and I could go on and on. The list of potential capacity constraints is getting longer and longer and is likely to add to inflationary pressures, should the economy continue to grow at a robust rate.

Whilst most short-term capacity constraints are likely to be workforce related, other constraints will increasingly pop up, and the reason is ageing of the capital stock. US corporates, not unlike corporates in many other countries, have under-invested for years. When the great bull market started around 1981, 25% of US GDP originated from corporate investments. Today that number has dropped to ca. 20% (see here), and the price is a rapidly ageing capital stock, which is ageing by two years every seven. US corporates have simply chosen to spend their free cash flow on buying back their own shares rather than spending it on new investments.

Furthermore, it should also be mentioned that a growing part of new debt goes towards servicing existing debt. Capital that could otherwise be spent on productivity enhancing investments is being used unproductively, accelerating the age of the capital stock and thus increasing the risk of rising inflation. Note: It is notoriously difficult to obtain reliable data on this statistic. Ironically, the best data that I have access to is from China, which suggests that 80% of all new Chinese debt (private and public) goes towards servicing existing debt. The number is much lower across the OECD but is still hovering around 30-40% in many countries.

Inflation to follow?

It is therefore not unreasonable to expect signs of inflationary pressure to pop up over the coming months (and years), and the more short-term growth momentum that the Trump factor generates, the more significant that pressure is likely to be.

I ought to mention that I am not alone in this view. Since Trump was elected in early November, longer term US inflation expectations have certainly risen (chart 4). To a degree, rising US inflation will therefore only have a limited impact on US financial markets, as some deterioration in inflation statistics is already discounted.

Chart 4: USD Inflation Swap 5Y5Y Forward
Chart 4: USD Inflation Swap 5Y5Y Forward
Source: The Daily Shot, Bloomberg, January 2017

There is a not insignificant risk, though, that financial markets dramatically underestimate the true inflationary impact from the dynamics just referred to, and it could quite possibly turn into something worse than ‘just’ a bout of modestly rising inflation.

Were that to happen, and were the Fed to react the way it would normally react, the 2 hikes in the Fed Funds rate that is widely anticipated for 2017 as a whole could prove grossly inadequate, and the Fed could effectively be forced to kick-start the next recession. The probability of stagflation creeping in in late 2017 or 2018 is therefore relatively high, but I should stress that I don’t see that happening at all in the Eurozone. There is still far too much excess capacity in most Eurozone countries for that to happen.

The European country most likely to catch the US ‘disease’ (were it to happen) is the UK, where capacity constraints are far more prevalent than in most other European countries. Adding to that, UK financial assets are also more highly correlated with US financial assets than Eurozone financial assets are. Should we run into a period of stagflation in the US, one would therefore expect UK financial markets to react more than Eurozone financial markets would.

Concluding comments

Firstly, I should emphasise that this is only the first part of my analysis. Part 2 will assess which asset classes and investment strategies one should be invested in, should we be facing a far more hostile Fed in 2017 (something we haven’t seen for over 10 years), should interest rates rise as a consequence, and should that lead to a recession or at least near recessionary-like conditions.

Secondly, I should stress that this analysis is based entirely on cyclical observations. In my opinion, interest rates are still trending down from a structural point of view – a point of view that may or may not be shared by the FOMC members. If indeed it is a viewpoint they share, it could potentially cause the Fed not to react as much as it would otherwise do to a spike in inflation.

In this context I should also mention that the Fed (and other central banks) may actually desire somewhat higher levels of inflation and interest rates, which would go a long way to address the problems in the pensions industry. It is therefore not entirely unthinkable that the Fed wouldn’t take as drastic action as one would normally expect them to take, given the circumstances.

Chart 5: US CPI for All Urban Consumers - Medical Care
Chart 5: US CPI for All Urban Consumers - Medical Care
Source: The Daily Shot, FRED, January 2017

Finally, I should point out that it is not only inflation expectations that are rising but also actual inflation – at least in certain parts of the economy. Take the consumer price index for medical care (chart 5). Prices are now rising as fast as they did immediately before the financial crisis, and it is very tempting to conclude that the election of Trump is already having an adverse impact on healthcare prices (but it is hard to prove).

All in all, given the inflation creeping in all over the US economy and the capacity constraints in play, I am going to stick my neck out and conclude that the Fed will simply be forced to take more decisive action as 2017 unfolds. 3-5 Fed hikes look – at least at this point in time – more likely than the 2 hikes that seem to be the consensus at present.

Part 2, which should be ready before the end of the month, will discuss in more detail how I believe your portfolio should be adapted to these changing conditions. I will include a review of traditional as well as alternative asset classes.

Niels Jensen

11 January 2017

About the Author

Niels Clemen Jensen founded Absolute Return Partners in 2002 and is Chief Investment Officer. He has over 30 years of investment banking and investment management experience and is author of The Absolute Return Letter.

In 2018, Harriman House published The End of Indexing, Niels' first book.