Testing the Fed’s Narrative with the Fed’s Data: QT Edition
If 2018 rings in a bear market, it could look something like the Kennedy Slide of 1962.
That was my conclusion in “Riding the Slide,” published in early September, where I showed that the Kennedy Slide was unique among bear markets of the last eighty years. It was the only bear that wasn’t obviously provoked by rising inflation, tightening monetary policy, deteriorating credit markets or, less commonly, world war or depression.
Moreover, market conditions leading up to the Slide should be familiar—they’re not too far from market conditions since Donald Trump won the 2016 presidential election. In the first year after Kennedy’s election, as in the first year after Trump’s election, inflation seemed under control, interest rates were low, credit spreads were tight, and the economy was growing. And, in both cases, the stock market was booming.
Here’s an updated look at Trump’s stock rally versus the Kennedy rally and subsequent Slide:
As you can see, we’ve now reached the chart’s critical juncture—at this time of the calendar in 1962, the post-election rally was ending, and the Slide was about to begin. Our chart begs the question: Will the similarities continue and lead us into a Trump Slide in early 2018?
Or, with less drama, you might like to hear my Q1 stock market outlook.
We’ve been seeing more and more commentaries discussing bad stuff that can happen when the Fed tightens policy and, as a result, the yield curve flattens. (See, for example, this piece from Citi Research and ZeroHedge.) No doubt, the Fed’s rate hikes will lead to mishaps as they usually do—in both markets and the economy. But most forecasters expect the economy to expand through next year, believing that the Fed and the yield curve aren’t yet restrictive enough to trigger a recession.
We won’t make a full-year 2018 forecast here, but we’ll share one of our “dashboard” charts that supports the consensus view for at least the first half of the year. With one methodological change to a chart we published in August, we’ll look at the following indicators, which together have an excellent track record predicting the business cycle:
In September, we proposed a theory of the Fed and suggested the FOMC will soon worry mostly about financial imbalances without much concern for recession risks. We reached that conclusion by weighing the reputational pitfalls faced by the economists on the committee, but now we’ll add more meat to our argument, using financial flows data released last week.
We’ve created two charts, beginning with a look at cumulative, inflation-adjusted asset gains during the last seven business cycles:
As reported earlier this morning by the Wall Street Journal, President Trump and Treasury Secretary Mnuchin met with Kevin Warsh yesterday to discuss the potential vacancy at the Fed next February.
Warsh already has central banking experience, having sat on the Federal Open Market Committee as a Fed governor from February 2006 until March 2011.
Two and a half years after he resigned from the Fed, he emerged as a vocal critic of FOMC policies, including policies he helped craft. He published an op-ed in the WSJ on November 12, 2013, and it was quite the editorial. As that happened to be the first week of hunting season, we suggested that Warsh had declared open season on his ex-colleagues, and we came up a gimmicky picture to go along with our reporting:
But we also thought his op-ed needed translation. It was written with the polite wording and between-the-lines meanings that you might expect from such an establishment figure. He seemed to be holding back, so we offered our guesses on what he was really trying to say. And with today’s breaking news, we thought we would reprint our translation.
So, if you’re wondering what the current frontrunner as Trump’s choice for the Fed chairmanship really thinks, here are Warsh’s comments on nine topics, followed by our translations.
The world hardly needs another theory of the Fed, especially so soon after its Jackson Hole symposium. But we have a theory, too, and who knows, ours could be as close to the bulls-eye as any of the others. Plus, our theory is easy to explain—it rests on the simple premise that decision makers worry mostly about their reputations. We’ll propose that reputational risks are the primary drivers of central bank policies, and then we’ll use that belief to predict a major policy shift.