Given all the confusion in the world around COVID, supply chains, inflation dynamics and war, there are lots of potential externalities that could resolve themselves unexpectedly. We call this the Deus ex Machina scenario. Our analysis follows in our Mid-Quarter Update.
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-Risky assets seem to be stuck between a rock and hard place, with inflation running at elevated levels, the Fed tightening and economic growth slowing.
-Academics insist the Fed needs to raise rates to a level above inflation in order to regain a neutral policy setting. They further argue that the Fed needs to go beyond neutral into restrictive territory to (ostensibly) cause a recession and crush aggregate demand.
-While we can see the logic of such prescriptions, we think there are two problems with this line of thinking: 1) risky assets are not behaving as if a recession or restrictive rates are in the offing, and 2) this path could bankrupt the US government.
-Given all the confusion in the world around COVID, supply chains, inflation dynamics and war, there are lots of potential externalities that could resolve themselves unexpectedly. We call this the Deus ex Machina scenario.
2. History suggests the Fed has significantly more tightening to go.
3. In the baseline Taylor Rule model, the suggested current policy rate is 9.69%.
This model assumes:
1) 2% real neutral rates
2) NAIRU of 5%
4. As of March 31, 2022, the CBO’s estimate of the non-accelerating rate of unemployment (NAIRU) is 4.44%. As the population ages, the NAIRU is in a demographic-driven structural decline.
5. So, if we tweak that one assumption and plug 4.44% in as the NAIRU variable, we still get a policy prescription rate of 9.13%.
6. OK, just for kicks, let’s make another huge tweak to the model by plugging in 0% real neutral rates. We’re still looking at a suggested policy rate of 7.13%.
7. Now, let’s go the other way and use the aggressive Taylor Rule Model. The big tweak in this model is the Okun coefficient rising from 0.5x to 1x. The Okun coefficient represents the degree of responsiveness of the unemployment rate to GDP variation. The higher the coefficient the less sensitive the labor market is to changes in GDP relative to potential, thereby prescribing higher rates to curb inflation.
8. US government debt is $30.5 trillion, having increased by over $4 trillion in 2020 alone.
9. Since the Great Financial Crisis, the US government has termed out its debt a bit longer. The average maturity of US government debt has gone from around 4 years to around 6 years.
11. Beginning in 2000, it is easy to see any sense of fiscal responsibility go out the window.
12. Budget deficits just structurally grew and grew. Twice in the last twenty years, we’ve run a budget deficit to GDP of 10% or more.
13. So, now we sit with a mountain of debt, totaling 123% of GDP at last reading. Importantly for anyone advocating for a Volcker-style rate smash, one needs to contextualize this around the fact that debt as a percentage of GDP was 30% in the 1970s. So, debt service shocks didn’t jeopardize the finances of the US government.
14. As mentioned earlier, the debt was easy to accumulate because it became cheaper and cheaper to finance. Here I show the debt service of the US by simply dividing annual interest expense by the debt level. Currently, the US government is running a debt service ratio of around 2%.
15. With the rise in rates we’ve experienced this year—as shown here by the 5-Year US Treasury—the projected debt service is going to move to 4% of GDP at a minimum. Any further rise in rates could take that debt service level higher and higher.
16. I created a simple multi-scenario analysis that calculates the amount of interest expense at different debt service levels. The 2% scenario is where we have been living (with about $600 billion/year interest expense), but the 5% scenario seems within reach given the rise in rates. At 5%, this step up in debt service will cost around $900 billion/year. Should the Taylor Rule Models suggest where the Fed is going, the debt service ratio could hit 10% or $2.9 trillion.
17. The problem with either scenario of rising debt service rates is funding them. If the debt service ratio went to 10%, interest would consume all tax receipts. Even at 5% (close to where we are probably heading), interest will consume almost half of all tax receipts.
18. To give some perspective on the size of budget expenditures, the US spends about $623 billion/year on national defense. Moving from a 2% debt service scenario to a 5% debt service scenario would require incremental interest 1.5x larger than the entire defense budget.
19. The CBO isn’t projecting a path that brings the country back to lower levels of debt. They have 4%+ deficits penciled in for the next decade.
20. Back to the baseline Taylor Rule Model, forecasts for core inflation and unemployment still prescribe a 7.25% fed funds rate by next summer. Considering fed funds futures, the market obviously doesn’t believe this.
21. The Fed simply can’t raise rates enough to properly combat inflation.
There are only a few paths here:
1) The Fed perseveres and raises rates to a level above inflation. By taming inflation with rates suggested by even the baseline Taylor Rule, the Fed will bankrupt the US government.
2) The Fed talks tough, but fails to raise rates to a level sufficient to tame inflation.
This seems to be the linear thinking model that academics describe. It may turn out to be true, but neither of these scenarios seem to justify why the market has been healthier for the last two months.
22. The Deus ex Machina scenario. This is our baseline scenario (though by definition, we can’t predict it).
This is, luckily, a longer list:
1) The war in Ukraine ends
2) Tensions surrounding Taiwan abate
3) Supply chains heal
4) Containable domestic financial crisis (LTCM style event?)
5) International financial crisis (China real estate?)
6) Domestic soft landing (with unemployment rising and wage rates moderating)
7) International recession (China?)
8) Greater cooperation from OPEC to pump more oil
9) The US shale patch cranks up production of gas and oil
10) Commodity prices continue to decline—especially food and energy
11) No new COVID variant emerges
12) Newer, more effective COVID vaccines arrive
13) New deal with Iran that could lead to greater oil flow
14) Early retirees returning to work force
15) Reduction or elimination of China tariffs
16) Chinese Yuan Devaluation
An LTCM-style event is emblematic of a leveraged trading strategy failing to pan out.
Okun’s law predicts a 1% drop in employment tends to be accompanied by a drop in GDP of around 2%.
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