Now what do we do about recession?

Outlook: The data plate is not interesting (wholesale sales and inventories) and no Fed speakers are scheduled. The original trouble-maker, St. Louis Fed Pres Bullard, said he prefers the Fed funds target at 3-3.25% by year-end. The CME FedWatch tool shows a mere 10.8% of Fed funds traders see that as likely. (www.cmegroup.com/trading/interest-rates/countdown-to-fomc.html).

We think Bullard will prevail—again. But first, bond market turmoil arising from acceptance of the Fed’s tightening plan. The 10-year yield has moved from 1.19% on Aug 8, 2021 to 1.52% at year-end to 2.50-2.68% this week. A Reader asked whether we will see a replay of 3/78 to 10/81 when the 30-year went from 8.24% to 14.49%.

The answer is no, for several reasons. First, we didn’t have QE in the late 1970’s. QE artificially reduced yields and nobody knows by how much. This is a key reason why yield curve inversion today that predicted past recessions is questionable.

History will not repeat exactly but some of it may rhyme. Consider that when yields were up in the stratosphere, they still delivered a real (after-inflation) return. Ed Yardeni rides to the rescue. See his chart of the 30-year. It was not a real negative for 42 years until QE came along in 2020, although falling since 1994.

The 10-year shows we had negative real rates in 1974, 1979, 2008, 2012, the last one without an accompanying recession. There’s plenty to quibble about in these charts, including the criticism that the timeframes should be shifted to show lag.

But quibbles miss the point that negative real returns are rare, unusual, and scare the pants off everybody, while not always driving capital to equities.

Second, which inflation metric are we using? The third Yardeni chart shows quite a divergence between two inflation measures. So, if the 10-year ends this calendar year at (say) 3.5%, it will still not be delivering any real yield if inflation remains at the Fed’s forecast of 4.3% by year-end (and 2.7% by end-2023).

Or worse, CPI. Let’s assume core CPI stays the same 6.4% in Feb (Trading Economics sees it rising to 6.7% in April for March, but put that aside). And let’s further assume it stays at 6.4% to year-end and does not moderate. If the 10-year yield is 3.5%, the negative yield is 2.90%. If we loosen the assumption and say inflation will be 4%, it’s still a negative.

Inflation forecast are all over the place. Everyone has one—the BIS, the OECD, the IMF, private economics organizations like the Peterson Institute, even Kiplinger (with 10%, wow). The breakevens have 3.28% in the 5-year and 2.83% in the 10-year. Obviously, several somebodies are going to be wrong.

Equally obviously, there is too much variability in the inflation forecasts for the upcoming Fed events to be properly priced in. As explained before, the pricing-in concept seems to be a corollary of the efficient markets hypothesis that pretty much fails empirical tests (as well as common sense). We would not get overshooting if events could be priced in properly. Besides, no one has a crystal ball. Sometimes it’s the idiots who control sentiment and it’s sentiment that determines price.

In order for the 10-year to deliver a meaningful real return, with inflation at 4-5%, that mean a nominal yield of 6-7%. The probability of getting that during this year is almost zero. What about 2023 or 2024? Well, maybe. But Fed talk of the neutral rate at 2-2.5% by then is just plain silly. They are going to have to rachet that up.

Now what do we do about recession? Markets expect the Fed to relent if recession arrives. The Fed says this time it won’t, but you never know. It held back on 50 bp in favor of 25 bp at the last FOMC meeting because of the Ukraine war. What can happen to change its mind again?

One clue might be companies’ willingness to invest in new production capacity. Capital spending plans are a proxy for future economic growth, aka GDP. The Atlanta Fed GDPNow model puts a lot of weight on it. Capital spending affects jobs as well as input/construction prices and output prices, too. If we are getting a recession, we expect capital formation to crash. See the chart of capital spending.

This is a prerequisite for recession as well as the proof if it. In the grand scheme of things, interest expense is not the top factor in the capital investment decision—it’s demand, plus the cost of inputs. As things like copper, steel and other inputs go nuts because of the war (like chips went nuts because of Covid), investment will likely fall.

A corollary is capacity utilization. High numbers imply inflationary pressure from within, so to speak. This is doubly dangerous with a raging labor shortage. Some producers can get more bang for the output buck by adding technology, but not if they are unwilling to invest new capital and lack the labor to operate it.

If we see capital spending fall while capacity utilization continues firm, inflation must rise and recession becomes increasing likely. This is a version of Econ 101 and we must admit there are offsets, like government spending and various schemes to bring the cost of energy down and keep it there. Bringing down the price of oil can head off recession all by itself.

An early end to the Russian war on Ukraine would bring down inflation and the price of oil by all itself, too. Say Germany did eschew Russian oil and gas, and the US/EU strong-arm currency buyers in Asia (India, Japan) to do the same. How long can Russia keep it up without oil and gas revenue? Reserves of over $630 billion are mostly locked and not available to the Kremlin. Is Putin really prepared to become Kim Jong-Un and Russia to become North Korea?

As a fantasy, pretend Russia halts the war before year-end. All this talk about inflation becomes worthless. Inflation might not nosedive but could stay relatively high for the more attractive reason that the world will need resources to rebuild Ukraine in some kind of Marshall Plan. But plans like that have ending points instead of deadly endless uncertainty. Inflation expectations can fall even as actual inflation is rising but in an environment in which everyone knows the ending point of special-purpose spending. Building materials—lumber, again!—will go up, but so will the exports of supplier countries, including real losers like Turkey. (Turkey makes vast amount of cement and gravel.)

A Reader mentioned that the West can force Russia to pay for rebuilding Ukraine—we already have its assets under our thumb. We had forgotten that Iraq compensated Kuwait for its destruction and pillaging after it invaded. Now that was a satisfying US military intervention—one week and the invaders were retreating, tail between their legs. Not that anyone should have nostalgia for any war.

Fantasies aside, higher inflation for longer is likely in our future and the bond boys have not accepted that yet and priced it into their issues. As for recession, it’s still a maybe. How is all this affecting the dollar? The FX market is a little confused itself. It was willing to go full-bore risk-on for a few days but then got scared and returned to the dollar.

As we said the other day, it’s “inflation, recession, Fed, Russia”–rinse and repeat. As soon as the bond market comes to accept the Fed means exactly what it says and will not be deterred again, yields “should” rise properly and perhaps de-invert. Equity traders will start to examine dividend yields vs. bond yields, although nobody thinks bonds can give equities a run for its money—yet. Throughout all this, logically the dollar should be the beneficiary, and not because it’s a safe haven, either. And yet, “Russia.”

Tidbit: We are always mightily impressed by the ingenuity of merchants. Europeans and Middle Easterners were getting tin from Tintagel in Cornwall in pre-history and well into the 13th and 14th centuries. Nowadays buyers of food are getting it from some unexpected places. As the UN reports, food prices are up 13% in the latest month alone. That inspires clever opportunism, not always a dirty word.

Bloomberg reports “Soaring freight costs, port closures and supply-chain constraints have slammed exports from the Black Sea. With the war threatening more than a quarter of the world’s wheat shipments and about a fifth of corn, the world is at risk of more severe food shortages and worsening hunger.

“Buyers are on the hunt for alternatives, and sellers are finding ways to fill the void. India, which tended to keep its large wheat harvests at home, is jumping into the export market with record volumes. Brazilian shipments for the first three months almost doubled those in all of last year. U.S. corn is going to Spain for the first time in four years, while Egypt is looking to swap fertilizer for Romanian grain and holding wheat talks with Argentina.” This is how famine is averted and eventually, inflation is pruned back.

This is an excerpt from “The Rockefeller Morning Briefing,” which is far larger (about 10 pages). The Briefing has been published every day for over 25 years and represents experienced analysis and insight. The report offers deep background and is not intended to guide FX trading. Rockefeller produces other reports (in spot and futures) for trading purposes.

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