Policy Mistakes

This note was originally published at 8am on June 02, 2015 for Hedgeye subscribers.

“Yes, I’ve found a flaw. I don’t know how significant or permanent it is. But I’ve been very distressed by that fact.”

-Alan Greenspan

In a solemn testimony to Congress way back in October 2008, former FOMC Chairman Alan Greenspan had that to say in response to the following question from Representative Henry A. Waxman (D-CA), which was in reference to the low interest rates and lax regulatory oversight of the securitization market which perpetuated the housing bubble:

“Do you feel that your ideology pushed you to make decisions that you wish you had not made?”

History has spoken loudly for Mr. Greenspan with respect to determining whether or not the Federal Reserve’s actions (or lack thereof in many cases) contributed to the most severe financial crisis since the Great Depression. And while they may not readily admit it, policymakers – like investors – do indeed make mistakes (see: Chart of the Day below).

Back to the Global Macro Grind…

If you’re in the camp that a rate hike(s) would be a dangerous mistake(s) for the FOMC to make at any point over the intermediate term, then you, like us, are definitely not in line with Wall St. consensus which came into the year expecting ~3% real GDP growth, ~2% core inflation and ~3-4% annual wage growth – for the sixth straight year, might we add.

If you’re in the aforementioned camp, you probably also agree with our lower-for-longer thesis on interest rates and expect the yield curve to flatten [perhaps materially] if the Fed embarks on what it believes to be a “policy normalization” cycle.

Recall that the 10Y Treasury Yield rallied +69bps in the three months preceding the first of 17 rate hikes back in June ’04. It proceeded to retrace all but 2bps of that rally over the NTM.

We bracketed “perhaps materially” earlier to highlight our #LateCycle Slowdown theme. As recently detailed in an institutional research note, trends across a variety of economic indicators put the U.S. economy roughly ~12 months away from recession.

While that may sound like good news to investors, our predictive tracking algorithm has YoY real GDP growth slowing throughout the balance of 2015. In lay terms, we believe the U.S. economy is past peak in rate-of-change terms and, much like in early 2007, the consistent and fervent missing of expectations for economic data appears set to continue on a trending basis throughout this period.

We underline “on a trending basis” to give a sincere golf clap for yesterday’s MAY ISM Manufacturing and APR Construction Spending beats. Additionally, the details of both reports were quite good on an absolute basis.

In the interest of not having perma bond bears tune us out, we’ll just ignore yesterday’s miss in Real PCE growth. Who cares about household consumption anyway? It’s only 69% of GDP.

For what it’s worth, the Atlanta Fed’s “GDPNow” model revised down its estimate for real consumption growth in 2Q by -50bps to +2.1% on yesterday’s print, but, again, I digress…

Another very important reason we consider it a mistake for the Fed to embark on what we believe to be a misguided “policy normalization” cycle is the current entropy of domestic and global demographic trends. Without recreating the wheel, here is the CliffsNotes version of our deep dive on this subject:

1. Aging has a statistically significant inverse relationship to both real GDP growth and inflation.
2. Both the U.S. and global economy are aging at their fastest rates ever. In the U.S.’s case, the rate of change in aging itself is +172% faster in the five years ended 2017 than it was in the five years ended 2011.
3. The flip side to accelerated domestic and global aging is slowing growth – and even outright contraction – in the world’s core consumption demographic, which, both empirically and theoretically, happens to be the 35-54 year-old population. In the U.S. in particular, the YoY rate of change turned negative in 2008 and is projected to remain negative through 2019. This compares to growth rates of +3.0% and +0.6%, on average, in 1990-99 and 2000-09, respectively.
4. As a result of this entropy, we believe both the U.S. and global economy are firmly entrenched in the process of seeing both potential growth and potential inflation – if there is such a thing – decline.
5. To the extent this hypothesis is indeed correct, we think the aforementioned consensus expectations are materially off base in that they are based off of models which do not take into account the aforementioned demographic changes.

So it’s up to you whether or not you choose to overweight the steep increase in the Prices Paid component of yesterday’s ISM Manufacturing report or the deceleration in the YoY rate-of-change in Core PCE, which is the Fed’s preferred inflation gauge; you can’t do both:

• MAY ISM Prices Paid: 49.5 from 40.5 prior. While still in contraction territory, 49.5 represents the highest reading since OCT ’14 and the +9pt MoM increase represents the fastest MoM increase since AUG ’12.
• APR Core PCE: +1.24% YoY from +1.32% prior. The +1.24% increase represents the slowest rate of inflation since FEB ’14 and marks the 38^th consecutive month below the Fed’s +2% target.

Here are three more lines in the sand investors must draw if they are to effectively handicap interest rate risk from here:

1. Do you side with the Fed’s [on-target] 5Y-Forward Breakeven Rate of 2% or do you believe the TIPS 5Y Breakeven Rate of 1.6% to be a more prescient indicator of inflation?
2. Do you side with the +34bps back-up in the 10Y Treasury Yield since its April 3^rd higher-low at 1.84% or do you believe the -1bps decline in the DEC ’15 Fed Funds Futures Implied Yield over that same time frame to be a more prescient indicator of the Fed’s likely path of policy? It’s worth noting that since April 3^rd, the implied probability of “liftoff” has declined -420bps, on average, across the five remaining FOMC meetings in 2015 with the December 16^th meeting being the highest at 53%.
3. Do you side with Bloomberg Consensus real GDP growth estimates which call for acceleration in QoQ SAAR terms throughout the balance of the year or do you believe Hedgeye Risk Management’s real GDP growth estimates which call for deceleration in YoY terms throughout the balance of the year to be a more prescient indicator of the direction of interest rates?

All told, the Hedgeye Macro Team reiterates its intermediate-to-long term bullish bias on bonds and bond-like equities.

Regarding the latter, we think the $3.5B in YTD redemptions from REITS and Utilities funds is somewhat reminiscent of investors broadly selling the 2009 lows in the broad equity market – specifically in the sense that we believe such selling is predicated on consensus fear (rate hikes now vs. Great Depression redo then) and not on thoughtful analysis of the underlying fundamentals (i.e. the economic cycle).

Our immediate-term Global Macro Risk Ranges are now:

UST 10yr Yield 1.99-2.28% (bearish)

SPX 2098-2122 (bullish)

USD 94.65-98.19 (bullish)
EUR/USD 1.08-1.12 (bearish)

Oil (WTI) 58.09-61.49 (bullish)

Gold 1175-1214 (bullish)

Keep your head on a swivel,

DD

Darius Dale

Associate