Back

Blogs

The New Neutral

Benjamin M. Lavine, CFA, CAIA

I sense it is about that time of year when we roll out our year-ahead outlooks, although the rush to release these outlooks reminds us of the race by retailers to roll back the start of the holiday shopping season (is it now Labor Day?).  Although a little later than others, 3D is jumping the turnstile by publishing a preview to our upcoming year-end market commentary and year-ahead outlook.

Neither this piece nor the 2017 year-end commentary will focus too heavily on cryptocurrencies although Bitcoin is dominating much of the marketplace headlines these days. However, with the launch of Bitcoin futures contracts and new financial outfits willing to lend on Bitcoin collateral (the future of shadow banking?), we are finding that plenty of other major issues are getting pushed to the sideline as it has become difficult to compete for investor attention fixated on a virtual asset that is up 1500% for the year. 

Yet, these other issues will likely surface as drivers of future market volatility as we head into 2018, especially with a market priced at narrow margins of error (whether cycle high equity valuations on forward earnings or cycle lows on fixed income credit spreads). 

Two major issues we see emerging in 2018 are:

1. How does the Federal Reserve manage U.S. rate policy in the face of a global economy that is heating up so late in what has been an elongated economic cycle?  The risks of either falling behind the inflation curve or pushing the economy into recession due to aggressive tightening seem more acute, especially under the auspices of a new Federal Reserve Board. 
2. As we wrote in the November 2017 market commentary, “Following the 19^th Community Part Congress, it appears that China’s President Xi Jinping is following through on efforts to ‘improve the quality of growth’ rather than growth for its own sake.  Such efforts include a regulatory crackdown on excess financial leverage as well as improving environmental conditions.”  Having witnessed the market and currency disruptions from prior regulatory crackdowns (August 2015 – February 2016), any future regulatory initiatives, although likely to be more measured, will still pose risks to near-term market stability. 

This article focuses on Issue #1, which we’ve termed “The New Neutral” as an extension of the “New Normal”.  Starting with the 2016 year-end market commentary, we’ve written several times over the past year on the tectonic forces of cyclical reflation versus secular disinflation.  The year started with the markets expecting cyclical reflation but have since settled into expectations for ‘more-of-the-same’ which has been low, non-inflationary-driven growth that has characterized much of this current cycle going back to the 2008 financial crisis. 

‘Reflation’ has yet to materialize despite strong employment trends as the theoretical Phillips Curve continues to get stretched out further.  Rather than cyclical reflation vs secular disinflation, this year has produced a third option which is non-inflationary growth that has favored growth technology stocks and cryptocurrencies.  So, in the battle of cyclical reflation versus secular disinflation, one can call it a draw.  And investors have celebrated this ‘draw’ by driving down investment risk premiums across equities, fixed income, and market volatility. 

But should we expect a similar outcome in 2018?

The New Neutral – Will 2018 See a Rise in the Natural Rate of Interest?

Beneath the Bitcoin mania surface, several strategists are highlighting the risks posed by Federal Reserve rate hikes that might translate into a sell-off of risky assets.  Will 2018 be the year that the Federal Reserve’s attempt to reverse emergency monetary measures and zero-rate policies finally see lift-off?

Given the false starts witnessed almost every year since the financial crisis whereby the Fed tries to normalize interest rates only to delay such normalization because the ‘data’ doesn’t support it, one couldn’t be blamed for having a healthy amount of skepticism that 2018 may turn out to be different from the prior years. 

Given the flattening of the yield curve and less-than-2% inflation priced into the difference between Treasury-Inflation-Protected Securities (TIPS) versus nominal Treasuries (Figure 1), the market does not appear to be concerned about inflation nor deflation. 

Figure 1: A Flattening Term Structure and Below 2% Expected Inflation Suggests Inflation Won’t Morph into a Long-Term Issue

Treasury investors are either anticipating that future economic data will come in weaker, which will cause the Fed to be more deliberate and patient in rate tightening or, more likely, the Fed will be too aggressive in raising rates, pushing the U.S. economy, still recovering from the 2008 financial crisis, back into recession. 

Yet, the economy is running near full capacity, if not already above capacity (Figure 2), and employment rates are at historically high levels. 

Figure 2 – The U.S. Economy Has Been Running Ahead of Its Potential for the Last 12 Quarters

Despite few inflationary pressures emerging in the form of labor costs or core inflation price indices, there has been an increased shift in the stance amongst Fed Watchers from ‘Will they or won’t they?’ to ‘How many’?’ – as in how many times the Federal Reserve will hike interest rates in the coming year.  Fed Funds Futures are pricing in three rate hikes by the end of 2018 (Figure 3).  Assuming a 0.25% rate hike this week, three rate hikes would put the Fed funds in the 1.75-2.00% range.

Figure 3 – Fed Funds Futures Pricing in Three Rate Hikes by the End of 2018

Source: Bloomberg

What many Fed watchers are warning, especially in light of a Republican-led tax plan expected to drive down corporate rates and increase domestic investment, is that the natural interest rate (r*), or the equilibrium rate that is consistent with stable inflation with an economy at full employment, is moving up.  Credit goes to Stifel Nicolaus strategist Barry Bannister for highlighting what may amount to be a difficult tightrope for the Federal Reserve to navigate in the upcoming year. 

The uncertainty (and opportunity?) undergirding the New Neutral is a rising r* as cyclical reflation (sustainable GDP growth) finally gains the upper hand on secular disinflation. 

Figure 4 displays the estimated natural interest rate based on the FRS Laubach/Williams model whose primary input is ‘sustainable GDP growth’ along with the real Federal Funds Rate (“FFR”) which is the FFR less the core deflator for personal consumption expenditures (“Core PCE”), the Fed’s preferred inflation measure.  The Fed is not oblivious to the closing of the GDP output gap; rate hikes that began in December 2015 has narrowed the difference between real FFR and r*.

Figure 4 – The New Neutral: Will a Rising R* Meet a Tightening Fed?

But does the Fed run the risk of tightening too aggressively?  A 2% FFR and 1.50% core PCE puts the real FFR at 0.50%, which may not seem much, but is well above r*.  This represents real tightening.  And 1.50% core PCE for 2018 may be too low of a forecast as Bloomberg is estimating core PCE (Figure 5) to come in at 1.7% (granted this is down from 2% estimated earlier in the year) compared to 1.4% for the October 2017 reading. 

Figure 5: Core Inflation to Run Hotter in 2018?

Something to consider as well is the risk of tightening financial conditions well above the sustainable natural rate of interest.  Prior periods that saw real FFR exceed r* have precipitated sharp pullbacks and even recessions.  So, the risk for 2018 is that three hikes could push the economy over the edge and sow the seeds for the next bear market. 

But notice that we wrote “the uncertainty” of the New Neutral versus the “the risk.”  The uncertainty is whether r* rises driven by increasing estimates of sustainable GDP growth.  The risk is that r* stays the same or collapses because sustainable GDP growth stalls out.  R* is also slow moving and won’t necessarily tick up if the U.S. economy experiences a GDP boost in 2018. But forecasting r* correctly will be critical for how well the Fed navigates monetary policy heading in 2018. 

Hopefully the reader can now appreciate the high wire act facing the Federal Reserve (occupied by a new group of governors and chairperson) in 2018, especially in light of the populist/politically-charged environment characterizing much of the developed world.  If the Federal Reserve overestimates r* and pushes the economy into recession due to rate tightening, it could very well face an existential threat to its charter.  However, if the Federal Reserve acts too slowly, they run the risk of falling behind the inflation curve and will be forced to play ‘catch up’ – a stagflationary scenario of higher inflation and weaker economic prospects. 

In other words, the tail-risk catalyst may very well be shifting from the White House to the Eccles Building come 2018. 

Based on the flattening term structure, the bond market is not buying into a rising r* and is skeptical of a rise in sustainable GDP growth.  Time will tell, and we may not find out should the Fed be too preemptive in its rate hikes.  But should r* rise and 2018 experiences the New Neutral, this should play out well for the reflation trade.

The above is the opinion of the author and should not be relied upon as investment advice or a forecast of the future. The projections or other information regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. It is not a recommendation, offer or solicitation to buy or sell any securities or implement any investment strategy. It is for informational purposes only. The above statistics, data, anecdotes and opinions of others are assumed to be true and accurate; however, 3D Asset Management does not warrant the accuracy of any of these. There is also no assurance that any of the above is all inclusive or complete. Past performance is no guarantee of future results. None of the services offered by 3D Asset Management are insured by the FDIC, and the reader is reminded that all investments contain risk. The opinions offered above are as of December 11, 2017, and are subject to change as influencing factors change. More detail regarding 3D Asset Management, its products, services, personnel, fees and investment methodologies are available in the firm’s Form ADV Part 2, which is available upon request by calling (860) 291-1998, option 2, or emailing sales@3dadvisor.com or visiting 3D’s website at www.3dadvisor.com.