A Little Common Cents for December 15, 2018….a very little

December 15, 2017, by John Norris

Outside of politics, the big headline for week was the FOMC (Federal Open Market Committee) meeting on Wednesday. This is the monetary policy making body of the Federal Reserve. In a move which surprised no one, the FOMC raised the overnight lending target rate between member banks from 1.25% to 1.50%. On Tuesday, the futures market put this at a 100% probability.

The big question is: just how aggressive with the Fed be in raising ‘rates’ in 2018?

As I type, the markets think there will be two rate hikes next year. If the people putting down bets are right about such things, the first will likely occur at the 3/21/2018 FOMC meeting. Right now, the odds are at 72.3% the overnight rate will go to 1.75% at that time.

That is a pretty high percent, so I would almost consider at least one rate hike a lock. In fact, there is currently a 94.2% probability the overnight rate will be at least 1.75% by the end of next calendar. The odds ate 67.2% ‘we’ will be at 2.00% or higher, and only 28.9% the overnight rate will be 2.25% or more.

So, unless something extraordinary happens, book one and make contingencies for another in 2018. If you have any Prime based floating debt, your effective interest rate will likely, more than probably, be 0.50% higher this time next year.

Of course, stranger things could happen, but I don’t really think they will.

For all the brain power at the Federal Reserve, the nuts & bolts are: bad things tend to happen when the Fed inverts the yield curve, either intentionally or unintentionally. This condition is when short-term borrowing rates are higher for banks than long-term lending ones. Although banks carry a higher percent in floating rate debt than previously, there are still enough fixed rate loans (and demand for them) that an inverted yield curve will indeed slow the extension of credit in the US economy.

Therefore, one would certain hope the brainiacs on the FOMC would put aside academic theory and put on their thinking caps if they/we get to a point when another rate hike would severely curtail borrowing and lending in the US. Given the current shape of the Treasury yield curve, we are ‘good to go’ with one rate hike. Two puts us in kind of nervous territory unless there is a change in long-term inflation expectations. Three would more than likely cause some type of slowdown in banking activity. Four, well, four would be a problem.

For those of us who have been in the industry for a while, the very idea a 2.50% overnight lending could be an economic crippler is kind of ridiculous. Then again, I wouldn’t have dreamt of a 2.25% 10-Year US Treasury Note when I started in the industry back in 1991, but that is what we have today. Shoot, I thought people were foolish to buy a 2-Year Note with a 3.125% coupon back in the day, and so did everyone else on the trading desk.

So, I am very hopeful the new Jerome Powell led Federal Reserve will put prudence ahead of mental gymnastics next year, and stop the ‘tightening’ at 2.00%…..unless something miraculous happens, either good or bad.

As for the ‘new Fed,’ things have changed quite a bit since I got into the industry. Way back then, a dude named Alan Greenspan was the Chairman of the Federal Reserve, and a weirder personality cult there never has been. He wasn’t handsome, charming or physically imposing by any normal definition, but, my goodness, the world’s financial markets hung on his every word. So much so, ‘we’ called him the Maestro, because he was conducting the world’s economy like a symphony. The only problem was he really wasn’t, and was only presiding over a unique time in US history in terms of demographic, societal, and technological shift(s).

Make no bones about it: during Greenspan’s watch, the largest, most well-educated and societally liberated generation in the history of mankind hit their peak earnings years and career stride….the Baby Boomers. At the same, a relatively small generation (by comparison) was beginning to hit retirement. It was a perfect storm for economic growth.

So much so, because of where I live, I have likened the entire 1990s to the 1999 Alabama Crimson Tide. The head coach that year, Mike DuBose, was a very fine defensive line coach and I will leave it at that. However, in 1999, he had a running back named Shaun Alexander and a left tackle called Chris Samuels. Both were All-Americans and 1st-round NFL draft picks.

In any event, the offensive was pretty simple: when in doubt, give Alexander the ball and let him run through the hole Samuels had opened. Do that 20 times a game, or so, and you end up with a 10-3 record. In truth, and I am not kidding, I probably could have coached that 1999 Tide team to at least 7 victories, without ever having coached a football team at any level. Saban? Shoot, he could have beaten the Cleveland Browns with that squad.

After those two left, whew, 2000 was one for the books, not in a good way, and Mike DuBose was the head coach at Northview HS in 2002. Let’s just say DuBose wasn’t the reason for the Tide’s success in 1999.

So to for Alan Greenspan and the economic boom of 1990s, but we all thought he was the cause back then. As hard as it is to believe today, it all kind of made sense at the time. However, as Warren Buffett is famous for saying (among other reasons): “only when the tide goes out do you discover who’s been swimming naked.” In no uncertain terms, that demographic shift started turning by the middle of the last decade, as the first of the Baby Boomers started hitting their 60s and there just weren’t enough of my generation, X, to fill in the gap.

Things were going to cool regardless, but, as a told a group today: “unfortunately, the once mighty Alan Greenspan left office largely with a whimper. Never before had there been such a visible and influential Chairman of the Federal Reserve AND there will likely not be another one of that magnitude for the remainder of my career.” To that end, if you had told me in, say, 1997 that Alan Greenspan would be largely a forgotten figure by 2017 I probably wouldn’t have believed you.

All of this has a point…

While politics and Washington intrigue might seem fascinating and make all the headlines (like this week’s election in Alabama, and it was hard not writing about that), the Federal Reserve has a greater ability to meaningfully impact the US economy in a contracted period of time. Put another way, outside of some unforeseen, chaotic geopolitical event in 2018, the biggest immediate threat to the US economy is the Federal Reserve doing something stupid…namely being too aggressive in taking ‘excess’ liquidity and credit expansion out of the US financial/banking system(s).

They could do this by focusing on their charts and econometrics, and ignoring the realities of banking. Isn’t that a funny thing to write? The central bank could screw things up by not by not paying attention to banking. Weird, but true.

I don’t think this is likely to happen for a few reasons: 1) while well-versed in both finance and bureaucracy, Jerome Powell is not an academically trained economist; 2) Jerome Powell has traditionally been somewhat ‘dovish’ when it comes to inflation, and; 3) no one will have the same latitude Alan Greenspan had back in the day to do whatever they want to do. Period.

As such, I am not concerned about the Fed in 2018 at this time. Things can change, but I would be pretty surprised. Therefore, the biggest threat to the US economy next year probably ain’t gonna be an inside job…if you catch my drift. Look to Europe, but that is a discussion for later.

 

Have a great weekend.

 

One more thing…..thank you Janet Yellen. It took you a little while to gain your footing and win over the markets, but ended up being a pretty darn good Chairwoman. Well done.