Home > Analogy, Commodities, Economy > Winter is Coming … But Not Here, Not Yet

Winter is Coming … But Not Here, Not Yet

We began 2014 with the perspective that the economy was limping along, barely surviving. A recession looked possible simply because the expansion was long in the tooth, but there weren’t any signs of it yet. Equity markets were priced for robust growth, which was clearly not likely to happen, but commodities and fixed-income markets were priced for disaster which was also not likely to happen. The investing risks were clearly tilted against stocks and bonds, given starting valuations, but although the economic landscape appeared weak it was not horrible.

Beginning 2015, the economic news is much better – at least, domestically. Unemployment is back to near levels associated with mid-cycle expansions, although there are still far too many people not in the workforce and a still-disturbing number of people who say they “want a job now” and would take one if offered (see chart, source Bloomberg).


More encouraging still, commercial bank credit growth is back to near 8% y/y, which is consistent with the booms of the past 30 years (see chart, source FRB). And this number excludes peer-to-peer lending and other sorts of credit growth that occur outside of the commercial bank framework, which is likely additive on a multi-year time frame.


The dollar is up and commodities are down, both of which are good for the US economy generally although bad for some groups of course (notably the oil patch). But the US is a net consumer of commodities, so commodity bear markets are good for US growth.

Outside of the US, though, things are looking decidedly worse. Although European core inflation recently surprised on the high side, it is still only at 0.8% and with GrExit a real possibility it is very hard to get bullish economically on the continent. China’s growth is softening. Emerging markets are not behaving well, especially the dollarized economies.

This recent development of the US as an island of relative tranquility in a sea of disquiet is interesting to me. Why are interest rates in the US so low, given that our economy is growing? 30-year interest rates at 2.5% and 10-year rates at 1.90%, with core inflation at 1.7% (and median inflation, as I like to point out because it isn’t influenced by outliers, at 2.3%) seems dissonant as the economy grows at 2.5%-3% and inflation in the US seems reasonably floored in the long run at 1.5%-2.0% as long as the Fed is credible.

This isn’t a new phenomenon, but I think the causes are new. Over the last five years, nominal interest rates were lower than they ought otherwise have been because the Fed was buying trillions of Treasuries and squeezing investors who needed to own fixed income. But the Fed is no longer buying and the Treasury is still issuing them. So I believe the causes of low interest rates now are different than the causes were over the last half-decade. Specifically, the causes of low interest rates in the last five years were sluggish global growth and extensive central bank QE; the causes currently are flight-to-quality related.

It seems weird to talk about a “flight to quality” in US bonds without stocks also plunging. But we have an analog for this period. Here is where I depart totally into intuition, which is in this case driven by experience. This period of interest rates declining while growth rises, as the economy continues a rebound after a long recession, with commodities declining and stocks rising, feels to me like late 1997. It feels like “Asian Contagion.”

Back in 1997, there was a lot of concern about how the Asian financial crisis would spill into US markets. Rates dropped (100bps in the 10y between July 1, 1997 and January 12, 1998), commodities dropped (the index now known as the Bloomberg Commodity Index fell 25% between October 1997 and June 1998), the S&P rallied (+23% from November 1997-April 1998), and GDP growth printed 5.2%, 3.1%, 4.0%, and 3.9% from 1997Q3 to 1998Q3. Meanwhile, Asian markets and economies were all but collapsing.

There was much fear at the time about the impact that the Asian Contagion would have on the US, but this country never caught a cold partly because (a) interest rates were depressed by the flight-to-quality and (b) declining commodities, especially energy, are bullish for US growth overall. We did not, of course, escape unscathed – later in 1998, a certain large hedge fund (which was small compared to some hedge funds today) threatened to cause large losses at some money center banks, and the Fed stepped in to save the day. That was a painful period in the equity market, but the effect from the Asian crisis was indirect rather than direct.

The parallels aren’t perfect; for one thing, bond yields are much lower and equity multiples much higher than their equivalents of the time, and commodities had already fallen very far before the recent slide. I would be reluctant to expect another hundred basis point rally in bonds and another large rally in stocks from these levels, although 1997-1999 saw these things. But history doesn’t repeat – it rhymes. I seem to hear this rhyme today.

Why does it matter? I think it matters because if I am right it means we are witnessing the end of long-term crisis-related markets, but they are masked by the arrival of short-term crisis-related markets. This means the unwind that we would have expected from the Fed’s ending of the purchase program – a slow return to normalcy – might instead end up looking like the unwind that we can get from short-term flight-to-quality crisis flows, which can be much more rapid. Again, this is all speculation and intuition, and I present no proof that I am right. I am merely proposing this speculation for my readers’ consumption and consideration.

  1. January 12, 2015 at 9:07 pm

    While I don’t disagree with your thesis, we have discussed exactly the same analogy on my desk, I think the one thing you might not be considering is that with the advent of ECB QE, which I am confident will come by the end of Q1, investors in Europe are going to look at Spanish Bonos and Italian BTP’s yielding less than US Treasuries and think, ‘this is crazy, I’d rather own the US than Italy for the same nominal yield. I think a much flatter yield curve is in our future…O/N – 10yr of 75bps?

  2. January 12, 2015 at 9:21 pm

    But you pick up fx risk if you are a European investor buying US, right? I don’t disagree that only official institutions will but periphery sovereign debt if the ecb buys it down to those yields. But they can buy German corporates and get better yield too, without fx risk.

    I am not necessarily bearish on treasuries. However if you’re going to buy 10y Tsys at 1%, I have to think that 10y tips at a positive real yield is a better deal (and less fx risk!)

  3. January 13, 2015 at 7:56 am

    It feels like a very true observation to me. Would you care to elaborate more on the shapes and times of this short-term flight-to-quality crisis unwind? The feeling is that it won’t start until the global disbalances go away, don’t you tnink?

    • January 13, 2015 at 10:58 am

      The Asian Contagion took a long time to work its way through the markets and the global economy. But the first 6 months or so was when most of the market moves happened, and then it was fair to bet against the prevailing trend. I suspect we’re close to the end of the bond and equity trends, which have been going for a few months (or longer) and are at very high relative valuations. Some of this will depend on whether the Fed follows through on their plans to hike rates. I don’t think they will, which means that the dollar will come under pressure at some point…which will reverse commodities pressure and any modest downward inflation pressure. I think once you see the Fed start to publicly back away (“we said 6 months but we didn’t mean it HAD to be 6 months. We were misinterpreted”) then that’s when we’ll see moves start to waver. Some of that has already started to happen but I want to see the dollar go flat to down for a bit before I get eager to go the other direction.

  4. January 14, 2015 at 10:40 am

    Very plausible, indeed. Thank you

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