License to Kill Gophers

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License to kill gophers by the government of the United Nations. Man, free to kill gophers at will. To kill, you must know your enemy, and in this case my enemy is a varmint. And a varmint will never quit – ever. They’re like the Viet Cong – Varmint Cong. So you have to fall back on superior intelligence and superior firepower. And that’s all she wrote.

-Bill Murray as Carl Spackler in Caddyshack

The Gopher.

Recessions. Policy makers loathe them. The human costs are real and obvious, but they also lose elections. The desire of central banks to forestall recession at all costs reminds us a bit of the war that groundskeeper Carl Spackler had with the gopher in the 1980 movie Caddyshack. ^[1] For those of us old enough to remember that classic movie, Spackler won a final pyrrhic victory against the gopher by planting explosives throughout the golf course – eventually destroying the very course he’d sworn to protect.

Today, it seems to us that the allegory for the golf course applies to central bank policy as it relates to financial markets. Initially, Spackler tried to use less dramatic methods to find and kill the gopher, but none of them worked. Those methods are akin to traditional rates policy. It is our view that the concept of a natural or neutral rate is anachronistic in a world where QE is global and in which capital can flow relatively freely based on national comparative advantages. Moreover, monetary policy is reflexive in that lower rates (whether through temporary or permanent open market operations) beget lower rates. The neutral rate is dynamically impacted not just by the real economy but also by policy itself.

Indeed, prolonged application of policy will result in an eventual neutral rate of zero in the United States, just as it has in much of the rest of the developed world. Extraordinary measures in monetary policy, like buying equities (à la the BoJ) are akin to the dynamite that Murray’s Spackler eventually deployed. After all, he had “a license to kill gophers by the government of the United Nations.” Indeed, it a united front of central banks that possess the license, as negatively yielding debt globally has topped $15.6 trillion (up from below $6 trillion in the third quarter of 2018). It’s only a matter of time before the course is left unplayable.

The Groundskeeper.

The Fed’s 25 bps ‘insurance cut’ will do little to prevent the eventual necessity of QE – that is, if the Fed’s goal is to prevent a recession at all costs, it will require dynamite.^[2] In my view, a 25 bps ‘insurance cut’ now and another 25 bps in September will do little to prevent the U.S. from succumbing to the global economic malaise (all developed market PMIs we track are now in contraction or neutral with the U.S. stagnant at a reading of 50.4). ^[3] We’re not alone in our assessment that, short of renewed QE, the Fed has little policy room.  MNI reported just prior to the most recent cut that former Fed director of the division of research, David Wilcox, said: “We’re currently at or near a cyclical peak, and yet the policy rate is still only 2.25% to 2.5%. That’s uncomfortably limited. I hope they will take steps to create more policy space for themselves.” In that same interview, Wilcox estimated the Fed was roughly 250 basis points short of policy space to fight the next recession. He noted that the central bank cut its policy rate by at least 500 bps in each of the past three downturns. Cantor’s global market Outlook expressed this very view in January of 2019. Again, it will be difficult for the Fed to forestall a recession without the use of dynamite.

We’ve already written in Epsilon Theory that ‘late cycle’ cuts are usually followed by recessions in the United States. We debunked analogies to 1995 and 1998 in our previous note Cake. It’s no coincidence that Chairman Powell introduced the concept of mid-cycle cut in his latest statement to avoid the perception that the Fed felt an economic downturn was imminent. Market participants cared little about his characterization. They simply wanted more. Just because Chairman Powell called it a mid-cycle cut doesn’t mean it is one. We now face a policy lull in August through September when many things can happen with the U.S. data. Services ISM recently missed expectations and appears to be following its historical course – tracking manufacturing ISM lower but with a lag. The rates markets have most recently been screaming loudly that the slowdown is about to occur here in the U.S., and they have been doing so globally (in Europe and Japan) for much longer.

We expect the PMI data over the next several days to continue to weaken, and we don’t think Chairman Powell will deliver what the markets want to hear at Jackson Hole. Last week, the spread from 3-month to 10-year treasuries inverted to over -40 bps and the 2-10 spread inverted, as I’ve been suggesting it would since January. As they always do, equity markets in the U.S. will eventually ‘get the joke.’ For those waiting for the real economic data to hit them over the head, it will already be too late. The sole bright spot is the U.S. consumer… but it always plays out this way. The consumer spends until s/he hits the credit wall. Lending standards are already beginning to tighten and labor markets are as good as they will get. That means they will only get worse. While lower rates are cushioning the blow from worsening fundamentals, they have never alone forestalled recession. ^[4] We believe the recent selloff is the beginning of a deeper correction as there is little to prevent the slide that has already begun

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[1] We’d also characterized central banks inability to spur inflation in the same way. We often written that the inability to catalyze inflation is a function of two principal factors: 1) globalization and 2) supply side effects. Globalization allows for the importation of deflation as capital and labor migrate to lower cost geographies, as the theory of comparative advantage suggests.  Monetary policy, which sets the cost of capital, sets the stage for a world in perpetual productive asset overcapacity – mostly in the developing world.

[2] Of course, the other groundskeeper ahead of the presidential election might be fiscal policy makers. However, with a divided House there is little that the president can do from a policy perspective (like a payroll tax deduction) that would forestall the slowdown. Even a ‘resolution’ of the trade war won’t do the trick as the root causes of the global slowdown are structural issues in places like Europe, Japan and China.

[3] Don’t be fooled; the U.S. economy is reliant on the global economy through a more complex global supply chain than ever before. About 39% of S&P revenues come from outside the United States and the global financial markets are inextricably intertwined.

[4] My one caveat to this assessment would be an immediate renewal of QE in the United States that drove long rates to close to zero. A renewal of QE in Europe is important, but until it includes high yield bonds and equity, it won’t have an efficacy. In the meantime, U.S. high yield has been a massive beneficiary of low global rates.