Central Banks Headed In The Hawkish Direction For The First Time In 9 Years

Hawkish For The First Time In 9 Years

The chart below is very interesting because it combines the Bank of England, the Fed, and the ECB’s policy to come up with a rolling 5 year average of rate changes. I would have used a 3 year average because I feel that 5 years is too delayed and because an entire business cycle is only a bit more than 5 years. The other obvious criticism of the chart is it includes the Bank of England instead of the Bank of Japan which is still going strong with its QE program and negative rates.

The coolest part of this chart is it includes the shadow rates which means it counts QE and balance sheet reductions. That affects the recent results in that it sends the 2012 trough lower and it pushes the current value higher. The ECB’s interest rate is still below zero and the QE is still €30 billion per month, but the hawkish expectations have advanced. The ECB will probably end QE in September and raise rates 10 basis points before the end of the year. The Bank of England is dealing with the negative economic effects of Brexit, so it still has its interest rate at 0.5%. The Bank of England’s balance sheet as a percentage of GDP peaked at 24.13% in 2013 and has fallen slightly since then.

The obvious reason this chart has moved towards the hawkish end after 9 years of being dovish is that the Fed has raised rates and has started to unwind QE. On Tuesday, Fed chair Powell will speak at a conference for the first time since being named chair. This will get the market up to speed on his plans for policy as the Fed is probably about halfway through the hike cycle and less than a quarter of the way through the balance sheet reduction cycle. This speech will tell the market what the Fed will do at the March meeting in 25 days. The Fed fund futures are pricing in an 83.1% chance of a rate hike.

The obvious takeaway from this chart is that the business cycle is nearing its end. It appears the monetary policy usually stays on the hawkish side for 2-3 years before a recession. Since the Fed, ECB, and possibly the Bank of England will be raising rates this year and will be headed in a hawkish direction with their balance sheets, this line will increase in the next 12-24 months. One important point is this shows the change in policy, which can be different from the actual effect on the economy. What I mean by that is the Fed has raised rates which means it’s going in the hawkish direction, but the overall policy is still dovish since the Fed funds rate is below the Taylor Rule and the CPI.

I think the Fed will switch to being hawkish next year since it will be unwinding the balance sheet at a pace of $50 billion per month. Therefore, this chart has the right idea. This business cycle may be different than the prior 3. The prior 3 cycles were all in an environment with declining bond yields and inflation. As you can see, in the 1970s, Fed policy got much more hawkish because inflation was roaring. I’m not saying that the next few years will see roaring inflation like the 1970s, but it is possible that the multi-decade decline in inflation and interest rates might be over. Even if its in a lateral pattern instead of a decline, that would be a different situation. The Fed has had rates below the Taylor Rule and CPI for the longest period in history. I’m not sure if that long dovish period means the hawkish period will be long to make up for past policy or if it will be short because the market and economy are hyper sensitive to rising interest rates.

Financial Conditions Ease

In an article last week, I said that investors shouldn’t be scared by the rising financial stress index. My reasoning was the index was delayed. It was a snapshot of the market at its worst. As you can see from the chart below, the index went down slightly in its latest update which is as of February 16th. It would be circular reasoning to be bearish because of this index. That would be like saying you are bearish on stocks now because they went down 2 weeks ago. Secondly, that blip was very small. It wasn’t close to the size of the 2016 weakness during the energy and emerging markets decline. The 2016 issue didn’t cause any domino effects, so this one shouldn’t either.

Future Growth Expectations

I like to look at the ECRI report to see which direction the economy is headed in. It has a good track record in the recent past as it predicted the 2016 slowdown in early 2015. It cratered in 2017 which signals the economy should weaken in 2018. The ECRI position is that the cyclical weakness will cancel out any economic growth created from the tax cut. One other aspect to keep in mind with GDP growth is that Q4 was boosted by the hurricane related repairs. That catalyst is no longer in place as most of the spending on rebuilding has occurred. Judging from the economic reports on Q1 so far, there doesn’t seem to be any acceleration in growth. The big difference we’re seeing as a result of the tax cuts is the increase in corporate profit expectations.

As you can see, the leading index bottomed in September 2017. I wonder if that was related to the hurricanes. Either way, this means the second half of 2018 will have faster growth than the first half. These reports are one of the reasons why I’m 99% sure there won’t be a recession in 2018. As you can see, the index declined in the past 2 weeks. If this ends up being a trend, it’s worrisome because it might be the downtrend that heads negative and forecasts a recession. This would be the first data point which confirms my expectation for a recession in the next 2 years.

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