SHI 3.21.18 FED Day: Following the Script

SHI 3.14.18 Trump, Tariffs, and Trade
March 14, 2018
SHI 3.28.18 History Repeats
March 28, 2018

Per the script, once again the FED raised short term rates by 0.25%.  What does this mean to you?  

 

As expected, the FED raised its benchmark federal-funds rate by 25 basis points.  This is the 6th increase of 25 basis points since December 17, 2015.  What does this mean to you?

  • If you have a loan tied to a short-term index, such as LIBOR and Prime, your rate will probably increase .25%.
  • Home loan rates are likely to decrease.
  • The probability of a recession within the next 12-18 months has increased.  

Read on and I’ll explain my thoughts.

 

Welcome to this week’s Steak House Index update.

 

If you are new to my blog, or you need a refresher on the SHI10, or its objective and methodology, I suggest you open and read the original BLOG: https://www.steakhouseindex.com/move-over-big-mac-index-here-comes-the-steak-house-index/


Why You Should Care:   The US economy and US dollar are the bedrock of the world’s economy.   This has been the case for decades … and will continue to be true for years to come.

Is the US economy expanding or contracting?

According to the IMF (the ‘International Monetary Fund’), the world’s annual GDP is almost $80 trillion today.

During the calendar year 2017, US nominal GDP increased by $833 billion … by an amount approximately equal to the market capitalization of Apple.  At the end of 2017, US ‘current dollar’ GDP was almost $20 trillion — about 25% of  the global total.    Other than China — a distant second at around $11 trillion — no other country is close.

The objective of the SHI10 and this blog is simple: To predict US GDP movement ahead of official economic releases — an important objective since BEA (the ‘Bureau of Economic Analysis’) gross domestic product data is outdated the day it’s released.

Historically, ‘personal consumption expenditures,’ or PCE, has been the largest component of US GDP growth — typically about 2/3 of all GDP growth.  In fact, the majority of all GDP increases (or declines) usually results from (increases or decreases in) consumer spending.  Consumer spending is clearly a critical financial metric.  In all likelihood, the most important financial metric.

The Steak House Index focuses right here … on the “consumer spending” metric.  I intend the SHI10 is to be predictive, anticipating where the economy is going – not where it’s been.


Taking action:  Keep up with this weekly BLOG update.  Not only will we cover the SHI and SHI10, but we’ll explore related items of economic importance.

If the SHI10 index moves appreciably -– either showing massive improvement or significant declines –- indicating growing economic strength or a potential recession, we’ll discuss possible actions at that time.


The BLOG:

I began writing this blog for two reasons.  The first, of course, is the topic interests me greatly.   And I knew a weekly deadline would impose a discipline that would ensure I stayed with it.   Publishing every Wednesday is challenging and time consuming.  But I enjoy it.

Foundationally, this blog is about the US business cycle.  Since the US first engaged in commerce hundreds of years ago, our economy has followed a fairly consistent pattern, both expanding and contracting.   In the early years of our republic, deep contractions often followed exuberant expansions.  During those expansions, general consensus expected continuity.    But eventually, something always derailed the the expansion.  When fear and anguish finally became deep and pervasive, the consensus concluded the dark days would last forever.   But, of course, they never did.

And while the cycle follows similar patterns today, the mechanics of today’s economy are different.   They are both far more complex and, at the same time, exceedingly more transparent.  Unlike 200 years ago, today information is both instantaneous and ubiquitous.  Today’s transparency doesn’t make the timing of a recession easier to forecast, but it does make the probability easier to identify.

And that is what today’s FED rate move telegraphs.   A recession just became more likely.  Why?

Because the cost of credit just increased again. And credit is the lifeblood of both consumer spending and business expansion.   As the cost of credit increases, expenditures will decrease.  This cause/effect mechanism never changes.  Make no mistake:  For all things, there is a tipping point.   Of course, we don’t know where it is.  But when the level of short term rates gets too high, we begin the slide into into recession; once it begins, a recession is a certainty.   Which, unfortunately, we’ll only know in retrospect.

On December 16, 2015, short term credit rates were tied to a FED funds rate of 0.25%.  Today that rate is 1.75% — a full 1.50% higher.    This 1.5% cumulative rate increase demands it toll.

Consider the cost to our federal government.  On 10/22/15, a 3-month Treasury bill yielded zero.  Nothing.  Meaning the US Treasury paid no interest to the holder of the bill.   On 3/5/18, that same instrument paid 1.70% to the holder.   Said another way, every $1 billion of 3-month Treasuries cost the US taxpayer $17 million per year more than it did just 2.5 years ago.   How much more does $1 trillion cost in this scenario?   $17 billion per year.   And unlike the US government, businesses and consumers have a choice.   Borrow or not?   If the answer is “not,” spending slips.   And as spending slips, recession pressures begin to build.

In this same way, consumer and business variable rate loans have grown considerably more expensive in the last 2 or so years.   The FED doesn’t raise rates to be malicious; they are simply following their script.  Their job is to keep the economy simmering without overheating.

Which means they sometimes overdo it.   They miss.  Of course, we don’t know when they will overdo it, we simply know we’re getting closer with each .25% rate increase.

Some would argue, perhaps correctly, that my concern is overblown.   A FED funds rate below 2% is extremely low by historical standards.  This is fact.   In fact, with the exception of the period following the “Dot Com Crash” of 2000 (2001 – 2004) the FED funds rate hasn’t been below 2% since 1961, a time when inflation (per the CPI) was in hibernation.    Take a look at this chart, courtesy of our friends at FRED:

 

Clearly, the FED funds rate and the CPI are highly correlated.   And one could argue that even at a 1.75% rate — or, say 2.5%, a rate many expect to see by the end of 2018, the FED funds rate will not ‘tip’ us into a recession.

But the flattening yield curve disagrees.  The 10-year bond has been range-bound for a month or so.   But the 3-month Treasury has increased significantly.   Here’s a one-year chart of the yield curve:

 

 

So a 1.75% FED funds rate is exceptionally low by historic standards.  True.  But, at the same time, so is the “natural” interest rate.  It, too, is exceptionally low.   Within this paradigm, a 1.75% rate is actually pretty high.  More on this later.

The FED is raising rates now because they are expecting GROWTH not INFLATION.   This is an important distinction.  In the 1960s and 1970s, the opposite was true.  Not today.  In fact, the FED is forecasting the ‘core’ PCE inflation rate to remain at, or below, 2% thru 2020 … at the same time we experience strong GDP growth.   In spite of their inflation forecast, they expect the unemployment rate to fall to 3.6%.

Remember, consumer spending accounts for about 70% of our annual GDP.   The yield curve movement is important, but we’re still fairly positive.  A meaningful dip in consumer spending is probably more indicative.  If consumer spending — for both durable and non-durable goods — begins to slip, I’ll become more concerned.

With this in mind, how well are flatiron Steaks selling this week?  Let’s head to the Steakhouses.  Let’s start with the trend report:

I’m guessing the weather in Boston has improved … and folks are looking for a good steak!   Generally, numbers have improved across the board — today’s SHI10 reading suggests our pricey eateries remain quite popular — and plenty of people are willing to trade their hard-earned cash for a sizzling and scintillating Filet Mignon.   Here’s the SHI10 report for today:

Why will home loan rates decline?  As the market internalizes this latest FED move, it’s likely long-term rates will slide.  This is a typical reaction as investors start considering a possible future recession.   If you’re considering buying a home or refinancing, you might want to see what happens to the 10-year Treasury over the next few days before you lock your rate.  🙂

Permit me to finish with this.  I suggest you read today’s FED ‘Federal Open Market Committee’ press release.  Here’s a URL link: https://www.federalreserve.gov/newsevents/pressreleases/monetary20180321a.htm

And I suggest you take a look at their “handout.”   Here’s a URL link: https://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20180321.pdf

Don’t worry.  We’re not in, or heading toward, a recession.  Not yet.   But we do want to remain predictive.   And so we are.

  • Terry Liebman

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