Yesterday saw US Q3 GDP report in at 2.6% YoY upon which President Joe Biden tweeted: “For months, doomsayers have been arguing that the US economy is in a recession and Congressional Republicans have been rooting for a downturn. But with today’s Third Quarter GDP Report, we got further evidence that our economic recovery is continuing to power forward.” Having looked at some of the numbers behind the headlines, one sadly cannot conclude anything other than that Biden is either economically illiterate or a brazen liar for, other than the headline, there was little which would excite even a high school student taking economics as an elective.
There are plenty of moving parts in the release but one which is hard to overlook is that when adjusted for inflation, the economy has gone nowhere over the past twelve months. And how could Biden have missed that minor detail that investment in residential housing has plunged by no less that 26% in response to the highest mortgage rates in as long as most potential buyers could remember. Although consumer spending was also weak, it was still positive albeit at a level which economists would normally expect to see during a recession. To call the US economy a dead man walking might be a bit drastic, but it is quite clearly gently trundling into a recession. How deep and how protracted that recession might become is impossible to tell and anybody who suggests that it might be a short and shallow one, a medium one or a deep and protracted one is most probably talking their book.
Wisdom is that the shape of the yield curve is the most reliable predictor of recession. That would be true although the extraordinary activity which the Federal Reserve has been involved in over the past decade has surely distorted the curve to such an extent that what we see might not quite be what we get. Since the inception of non-standard policy measures – that’s quantitative easing to you and me – the principal objective has been to manipulate the shape of the curve or, more simply put, to keep medium term and long rates as low as could be. By mid-April of 2022, the Fed’s balance sheet had expanded to its peak of US$ 8.955 trn which equates to about 30% of the total national debt of US$ 31 trn.
Enter, stage left, QT or quantitative tightening, which describes the process of balance sheet reduction. Part of the result was – or is – to have been the release of long-term rates back into the hands of demand and supply, of the markets. As of October 10th, the most recently reported date, that had declined to US$ 8,744 trn or just over US$200 bn. Thus, the Fed still has the US Treasury bond market by the gonads, and it is therefore anybody’s guess what the market would look like, were it not still substantially under the control of the central bank.
In the eurozone things are even more complicated. The ECB did its bit yesterday as it raised the key rates by 75 bps to which took the marginal lending rate to 2.25%, the refi rate to 2% and the deposit rate to 1.5%. The ECB has been well behind its peers in tightening monetary conditions and, with inflation at or around 10% in both Germany and France, the adjustment could not have been any timelier. Mary Poppins sang “Just a spoon full of sugar helps the medicine go down” so, donning her frilly blouse and apron, ECB President Christine Lagarde pointed out that there is recessionary risk afoot which sort of not so subtly indicated that this aggressive looking monetary policy might be of limited duration. Yesterday’s will not have been the last move and there will be more to come at the next ECB Central Council meeting but after that interest rate policy be on a meeting-by-meeting basis and made up on the fly.
In a most outstanding piece for Bloomberg, my fellow Teenage Scribbler Marcus Ashworth dug a little deeper and highlighted that raising rates and promising to persist with the QT plans is the easy bit. Since the GFC, the eurozone crisis and the pandemic, the ECB has instituted more financial market support tools than one can shake a stick at. In the same way in which the Fed is uniquely creative in coming up with slogans such as “tapering” or “pivoting” and so on, so the ECB has more acronyms for its market support measures than there are letters in the alphabet. Ashworth points out that the mesh of the ECB’s emergency lending programmes is now so complex that it must be doubly careful of triggering unintended consequences. One of the most evident issues it to be found in TLTRTO – Targeted Longer-Term Refinancing Operations – which was aimed at encouraging banks to maintain the flow of credit to businesses and to the economy. Much of this went out at 1% and now the ECB’s deposit rate is 1.5%. So, banks which have borrowed from the ECB at 1% can, in theory at least, now lend that money straight back to them at 1.5%. Oops!
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Former ECB President Mario Draghi’s “…whatever it takes…” policy is not exactly unravelling although it is presenting his successor as well as markets with some serious headaches. Having just alluded to the Fed and its balance sheet, one should not underestimate what the ECB has done in terms of bond buying. But, whereas the Fed has been out there doing what it did in support of one large economy, the ECB has been burdened with the overtly political task of preventing the weakest in the herd of being isolated and brought down. Greece and Italy are the two which immediately spring to mind. Political correctness, and a jolly good kick in the shins by the ECB, has suppressed the use by research teams of once common sobriquets such as “the Garlic Belt” or the “PIGS” – Portugal, Italy, Greece and Spain – so that in a strange way public discourse has been manipulated away from those members.
Another great ECB acronym is PEPP, the Pandemic Emergency Purchase Programme, which was added to the APP, the Asset Purchase Programme. Between the two of them and added to the regular ECB balance sheet, they have mopped up well over € 8.5 trn in eurozone securities. Formerly immutable rules had to be re-written so that the debt of non-investment grade sovereigns could be booked and, although it is never spoken about at official level, it is evident that without significant ECB support, some of the weakest members of the eurozone would have long gone to the wall. How to reverse QE without letting the air out of the life raft? A curious side-effect of the support programmes is that there is now so little collateral in free float that long end rates which should be rising in line with the front end are not doing so. More buyers at supposedly more attractive rates that stock available.
The author is a retired City trader specialising in fixed income who now works as a freelance strategy consultant.
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