Given recent economic data, it's hard to imagine why interest rates, both short and long, are not rising.  Nominal GDP is growing at the fastest pace since 1951 (yoy% change), inflation is running at the hottest pace since 1990, and both equity markets and home prices are at all-time highs.  Yet, both the Fed and the interest rate futures markets are signaling you that we aren't likely to see rising short rates until 2023.  How can this be?

There is an important driver of economic growth, typically post-recessionary, that the central banks need to manage around, it is referred to as "fiscal impulse."  During economic declines, both the Fed and the Government will inject stimulus, in some form or fashion, into the system to stimulate economic growth.  This stimulus works with a lag; it takes time to flow through the entire economy and start to really have a positive impact on economic growth.  Given the economic damage done by the great financial crisis and the pandemic, there have been mass amounts of stimulus added to the system and the problem for central bankers is, once all that stimulus is gone, there will be a drag on the economy for a period of time.  The greater the amount of stimulus, the longer the drag.  The chart below shows this well.  It also helps explain one reason why the first rate increase is all the way out in 2023.  It is constructed and maintained by the Hutchins Center at the Brookings Institute.  They call it their "Fiscal Impact Measure" and it captures the implied amount of GDP impact that stimulus has.  As the chart shows, we are headed for a period of downward pressure on GDP growth (between 2.5% to 3% drag) due to the fiscal stimulus ending its "life cycle."  This implies that GDP growth will fall over the next couple of years back down to average growth, roughly 2%.  If the Fed were to tighten monetary policy during this time period, it could quickly lead to very tight monetary conditions, leading to a recession.  


 

At the top and bottom of every business cycle, interest rate transitions are inevitable.  Interest rates fall in a weak, deflationary economic environment, and rise in a strong, inflationary economic environment.  In debt-laden economies, the speed of the transition is what is important, not the absolute rate.  Especially with rising interest rates.  When interest rates rise too fast, things tend to break.  So how fast is too fast? 

In the chart below, I have taken the change in yield on the 10-year Treasury bond over a one year period.  I then measure that change against the long-term average rate of that 10-year Treasury bond.  As you can see, there is definitely a point where either credit problems develop, or where asset prices (fueled by debt growth) hit a ceiling and reverse direction.  If you review history, you will see that all of these peaks (red peaks) correspond very well with past crises.  



What is also obvious is that today, the 10-year Treasury bond has risen too fast, at least according to history.  Does this mean that a crisis or market crash is about to happen?  Not necessarily.  But what it does mean is that you can expect more interference with bond yields from the Fed and, sooner rather than later.  We will talk more about this at the April 9th ALMEdge webinar.  

Great news, sort of.  According to my very broad master economic model, the recession has ended as of September.  This would make it the shortest, deepest recession in modern times.  Of course, we won't know the official end date until NBER actually comes out with their official announcement.



This is no doubt good news, but, as is always the case with economic forecasts, there is one big caveat.  The next chart separates the model data into monetary components (think stimulus) and economic components (think real activity).  It clearly shows that significant parts of the US economy have not reached a self-sustaining mode yet.  The economy is still very dependent on stimulus from both the Fed and Washington.  If either of these source dry up, it is likely the economy will slide right back into recession.  Gee, isn't that comforting, reliance on the Fed and Washington, funny stuff.