Yield Curve Flattens - Is A Trump Recession Looming?

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by: Daniel R Moore

Summary

Trump's election is a potential game changer for the Keynesian fiscal policy status quo in Washington.

Interest rates spiked higher across the board in late 2016 in anticipation of potential major fiscal policy changes.

Since early March 2017, however, the yield curve has flattened, sometimes an indicator of a looming recession.

In 1949, under similar monetary and fiscal policy market dynamics, the US economy experienced a recession and US stocks fell over 20% in a 12-month time frame.

This article compares and contrasts the current financial market to that faced by Harry Truman in 1949 when the Fed was also raising rates off the zero lower bound.

The Treasury yield curve has become much flatter since the Fed raised interest rates in December 2016 and then again in March 2017. The targeted fed funds rate has increased 0.5% since December. In response, the long end of the curve after rising for much of 2016, culminating in a sharp rise right after Trump's election, stagnated, and then in mid-April began to fall.

Investors who have a exposure to Treasuries or other fixed income securities, or in stocks, need to assess what information the changing yield curve is sending about future market conditions. In the highly liquid Treasury market (NYSEARCA:TLT) (NYSEARCA:SHY) (NYSEARCA:IEI), under normal circumstances, a compression of the short and long end of the curve is a clear signal that investors have become risk averse. In many cases in financial history, the short and long end of the yield curve actually inverted prior to the economy contracting. However, waiting for a yield curve inversion signal in the current low interest rate environment would be foolish money management in my opinion. The current Fed, through the use of capital controls (paying interest on excess reserves, Dodd-Frank bank capital requirements to control lending), has become a much more active agent in managing (meddling in) the US economy. The change occurred in the transition from Chairman Greenspan to Bernanke and has been carried forward by Fed Chair Yellen.

The impetus for the shift occurred in the 2008 mortgage crisis, which gave cover for the Washington political machine to socialize the Fed by claiming the country was experiencing economic conditions similar to the Great Depression of the 1930s. As a result, just as in the Depression time period, the US debt grew, by choice of lawmakers in Washington, to over 100% of GDP, and the Fed was put into a position of having to control interest rates so that the interest charges on the increase in federal spending to jolt the economy out of the "Great Recession" did not spoil the political plan to expand the entitlement state.

The order of events has given the current Federal Reserve immense responsibility, and power, as long as the status quo is maintained. By this I mean they have a large balance sheet of US Treasuries which if unleashed on the open market would surely cause financial panic as investors stampede out of riskier assets into government bonds. But at the same time, the Fed has been "socialized" and has only limited choices in its ability to change the path which Washington has put the country on, unless there is a dramatic change in the fiscal policies approved in Washington.

Trump Election a Potential Game Changer from the Keynesian Status Quo

Unexpected to the mainstream political elites, left and right leaning, along came Donald Trump. The knee jerk reaction to Trump's election in November 2016 was a risk-on move, with higher long-term rates as Treasuries sold off and riskier assets like equities were purchased by investors. This trend led to new all-time highs being reached by the DOW (NYSEARCA:DIA), S&P 500 (NYSEARCA:SPY) and the NASDAQ (NASDAQ:QQQ). The market foresaw, right or wrong as it remains to be determined, that Trump fiscal and trade policies might potentially break the stagnant cycle that was causing persistent less than 2% real GDP growth and inflation which was virtually non-existent over the past 8 years, as measured by the CPI.

The Fed used the change in market expectations as Trump was elected to lift the short-term interest rate target in the US by 50 basis points in late 2016 and early 2017. And, as the graph above shows, the longer end of the Treasury yield curve has now begun to react negatively. The slowdown in the Trump economic policy initiatives are a definite factor, starting with a rejection of the Obamacare Repeal and Replace plan put forward in the House of Representatives, and a clear severe distaste for many seeking tax reform for Trump's border tax proposal. The market appears to be discounting the potential success of the Trump plan, and moving back to the Congressional stalemate position that existed pre-election.

An important question, therefore, is what will happen in the financial markets and US economy if little to nothing is accomplished in terms of Healthcare or Tax Reform in 2017?

Déjà vu - Financial Market Saw Similar Circumstances in 1948-49

Here is an interesting Jeopardy trivia question for readers. On the days leading up to the election of this US President, the pundits were all forecasting a resounding win for the other party's candidate. On the morning after the election, America woke up to the opposite result.

Who is Donald Trump? Sorry, the answer I was looking for was Harry S. Truman in his upset victory over Thomas E. Dewey in 1948.

In both instances, the mainstream media was completely off the mark in predicting the final election results. This coincidental circumstance does not mean the two candidates, or how they did or will govern are by any means similar. However, the two time periods have some very important similarities in terms of fiscal and monetary policies in place as they entered their term as President.

First, an important distinction is that Truman carried forward the Keynesian based FDR "New Deal Democrat" legacy, changing it only slightly to the "Fair Deal" in his domestic initiatives in his 2nd term. Truman was already in the White House having taken over after FDR's death in April 1945. His first major initiative in 1946 was to scale back the massive WWII federal spending budget, bringing the federal budget back into balance and beginning to whittle down the nation's debt to GDP ratio which had grown to over 100%. The circumstances surrounding the Truman election are far more akin to Hillary Clinton winning in 2016 and continuing the Obama legacy.

From the outset, Trump from a political agenda standpoint is, in my assessment, much more an opposite of Truman. However, the circumstances he inherited when moving into the POTUS position in 2017 look eerily similar in many ways to what Truman faced in 1949. I have assembled a table to summarize the two situations from a statistical and qualitative standpoint:

In the beginning of 1949, the US was coming off a high GDP growth year and unemployment was very low. Inflation was high, but a slowdown in price increases was in the making. The major domestic policy initiatives involved continued efforts to expand the social entitlement programs, with healthcare and jobs being the primary focal points. On the foreign policy front, the Marshall Plan was signed into law in April 1948. The program channeled more than $13 billion in aid to Europe between 1948 and 1951. The plan was meant to spark economic recovery in European countries devastated by World War II and provide a broader market for American goods.

Over the intermediate term, the Marshall Plan and the Fair Deal did not keep the US economy from contracting. In 1949, the impact on the US economy was quantifiably negative as a recession ensued post Truman's 2nd term election lasting from January to August 1949 (see NBER data here). The stock market as measured by the DJIA, peaked around 191 (month end data) in May of 1948, and fell to 166 by May of 1949.

Interestingly, the circumstances haunting Truman's second term involved constantly rebuking charges that people within the administration where corrupt Communist sympathizers and his biggest foreign hotspot was Korea. Foreign policy and constantly fighting the political accusations most likely curtailed advancement of Truman's domestic agenda. At the start of his administration in 2017, Trump is currently being consumed by foreign hotspots in North Korea and the Middle East, while having to rebuke political charges of campaign ties to Russia. These events may prove similar to Truman as distractions which could derail Trump's domestic economic agenda.

Similarities of Fed Interest Rate Policies in 1949 to 2017

Probably the most striking similarity economically between 2017 and 1949 can be found in the structure of the Treasury yield curve. If you go back the first graph in this article (inserted below), you will see the strong similarity between the yield curves in 2016 through early 2017 compared to the 1947 through 1949 time period.

In both cases, the Fed was, and still is today, trying to lift interest rates off of the zero lower bound. Large scale public financing increases to fund new entitlement programs and major wars in both time periods created the strain on the US balance sheet, pushing the Fed to drive interest rates to zero. Experiencing some improvement in the US government debt situation along with a growing economy in 1947, the Fed took the opportunity to begin increasing rates. As they began to increase rates, long-term rates lifted in unison. However, after the Fed had increased rates over 50 basis points, the long end of the curve began to contract. Going into the Presidential election in 1948, the 5-year belly of the curve did bounce higher; however, the increase did not hold and post election longer term rates began to fall more quickly despite the Fed continuing to push rates up on the short-end of the curve. Eventually, in early 1949 as the market came to grips with the beginning of an economic recession, money flowed from stocks to bonds for safety. Eventually, the Fed had to cut short-term rates back below 1%.

Matching the yield curve today to the late 1940s, in my assessment the market is reacting in 2017 in a very similar way to early 1948 (not 1949). Although the post-election reaction to Truman and Trump looks strikingly similar, I would say the market is not currently responding to an actual recession as it was in the 1949 time period. The market may yet experience a similar outcome in the next 6-12 months, but presently it is digesting the Fed rate increases on the short-end of the curve within a market framework of capital controlled Treasury inventory availability similar to experience in 1947-48.

Debt Ceiling Constraining Treasury Borrowing Temporarily - Major Funding Pressure Building

Why am I fairly confident that the current yield curve rate compression is technical rather than a sign of impending recession? Take a look at the Treasury net borrowing schedule since November of 2015.

The graph shows that President elect Trump was left with money on the Treasury balance sheet, but no remaining approved increase in the $19.8T debt ceiling in order to enter the public market thereby increasing the national debt. The Obama administration used up the entire financial limit authorized for Treasury borrowing prior to leaving office, with the last large new borrowings taking place in November of 2016. (As a note, I have labeled the large borrowings done by Treasury in November 2015 which coincide with the Obama administration Iran deal. All government programs, whether in the fiscal budget, or outside the budget, must still be financed.)

The debt ceiling is set to be reviewed and increased by Congress in late April. Once the Treasury returns to the market, I expect a rebound in the long end of the curve over the intermediate term. How far up the market can rise depends on the government's appetite for additional funding weighed against the ability of the Fed to keep rates low through incentives for banks to maintain excess reserves as well as another big factor that did not exist in the 1940s - foreign investment demand.

ECB Negative Rates Skewing US Borrowing Rates Lower - Watch out when ECB Tapers

In capital markets, there is an adage that "money flows where it is best treated". In the world market, the European Central Bank, ECB, and the Japanese Central Bank, JCB, have undertaken negative reserve interest rate policies over the last 2-3 years which have had the affect of pushing capital out of their own currency into alternative currency fixed income investments. In the ECB case, an FT Alphaville article (see here) published by Matthew C. Klein in February of 2017 shows just how large an impact the ECB policy has had on international capital flows, particularly in the short-term debt securities market.

In total, over $1.2T in Euro outflows have been experience, much of which either directly or indirectly has entered the US fixed income market keeping the Feds job of maintaining low US interest rates much easier. But, notice the curtailing of the outflows in the fall of 2016, just prior to the Fed taking action to raise short-term rates. It was at this point in time that the yield earned on currency hedged instruments into US fixed income reached a tipping point and the markets forced the Fed to raise rates.

The more important question that this set of data raises is just what happens when Mario Draghi begins to taper the ECB bond buying program?

Look for Upward Rate Pressure to Return in Intermediate Term

Currently, I expect US Treasury rates to stabilize at current levels and begin to climb again going into the summer of 2017 once the debt ceiling is lifted and the true costs of the current Trump military initiatives and the on-going entitlement burn rate continues to push the US debt balance higher. The 2.60% level on the 10-year Treasury bond (NYSEARCA:IEF) (NYSEARCA:TLH) is currently the risk-on trade upper boundary mark. If through the remainder of the year the Trump economic agenda continues to have trouble gaining Congressional support, then I expect economic conditions to deteriorate and the next leg down for the long-end of the curve will be a recession indicator. If the Trump program passes, the more aggressive it is in terms of tax cuts that require public financing and border taxes that drive inflation, the higher interest rates can potentially go.

One of the big differences between 2017 and 1948 is that the debt to GDP was improving as Truman approached his second term due to fiscal spending constraints and accelerating economic growth; Trump has inherited a deteriorating balance sheet financially. Currently, international buyers of US debt, particularly China, are lowering their exposure to US Treasuries. Eventually, the ECB will have to taper as inflation returns in Europe. All of these factors are coalescing at the same time period Trump is pushing forward a domestic agenda which will potentially cut the inflow of tax dollars in exchange for the promise of higher economic growth in the future. Who, I ask rhetorically, is going to step forward and finance the gap with interest rates as low as they are today?

An alternative outcome in the future path for rates could be very similar to the Truman experience if the Trump economic agenda fails to pass, or is greatly watered down. If the Democrats plus the Republican Freedom Caucus are successful in blocking most all of Trump's domestic economic initiatives, the country is left with the Keynesian status quo left by Obama. Under similar political circumstances in 1948, Truman suffered a recession in 1949 which then triggered his ability to get limited new Keynesian based initiatives approved.

Is a Trump recession required before the current fiscal status quo in Washington can be truly changed? Currently, I think the odds are increasing that this will be the eventual economic path for the United States.

Daniel Moore is the author of the book Theory of Financial Relativity. All opinions and analyses shared in this article are expressly his own, and intended for information purposes only and not advice to buy or sell.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.