The Wall Of Liquidity Is Coming
Summary & Key Takeaways:
The Federal Reserve and central banks worldwide are in full blown easing mode.
While some economic data supports ate cuts, but financial conditions do not.
Despite this, J. Powell and the Fed are intent on easing monetary policy.
The window for the Fed to ease is open. Expect them to take full advantage.
Cutting rates into a robust US economy will support the business cycle, increase liquidity and add a significant tailwind to risk assets over the medium-term.
The economy is weaker, but robust
From an economic perspective, the US is doing just fine. Yes, the economy has weakened in recent months. But no, we are not in recession. Nominal GDP is running at >4% and although the unemployment rate has ticked up of late it is still at only 4.1%. For reference, at no point from the middle of 2000 until mid-2017 did unemployment reach the current lows.
We can see below the recent trends in overall economic activity via my coincident Business Cycle Index and the Conference Board’s Coincident Economic Index. Economic growth saw a trough in 2022 amidst a swift deceleration that followed the record 2021 expansion, and has since trended sideways to slightly down, but still expanding.
Economic growth has simply not weakened enough to justify aggressive rate cuts.
And, as we can see below, outside of weakness in industrial production (the manufacturing sector) and some areas of consumer spending (retail sales), most key economic data are still growing at average or slightly below average levels. Importantly, real personal consumption and real incomes ex-government transfers receipts are still growing at above average rates relative to the past two decades.
But, if you are a policy maker who wants to cut rates and needs economic data to warrant monetary easing, then it is true some weakness can be found. As mentioned, manufacturing activity is weak, and it is not just industrial production supporting that notion, manufacturing PMI’s have also moved lower in recent months. There are areas of the economy that will benefit from easier financial conditions.
But again, on a holistic basis, monetary policy relative to economic activity appears neither too loose nor too tight following September’s 50 basis point cut.
Given we know the Fed wants to cut rates and is likely to do so until it is clear economic data simply doesn’t support cutting rates, the economy has cooled sufficient to “justify” easier monetary policy. So, expect the Fed to take advantage while they can.
The inflation battle is over, but the war is not
The inflation story is almost identical to that of the overall business cycle. Inflation is not at levels that necessarily need easier monetary policy, but the data does support rate hikes either.
As it stands, inflation measures have cooled significantly over the past 24 months, as we know, but none are below the Fed’s 2% target.
In terms of the CPI components ex-food and energy, the primary driver of the recent bout of disinflation has been the collapse in Core Goods CPI (which has been outright deflationary for quite a while now), along with the steady decline in Shelter CPI. Service CPI ex-Shelter has proved much stickier, and remains well above its 2010-2020 average (as does Shelter CPI for that matter).
But again, we have seen a significant amount of disinflation over the past couple of years. Even following the initial cut by the Fed, you could make the argument monetary policy is tight versus inflation. Assuming Core CPI remains around the 2-2.5% area for the rest of 2024, there is scope for the Fed to cut the policy rate by upwards of 200 basis points before we enter the “too loose” side of the monetary policy equation.
History suggests it is uncommon for the Fed to cut rates with such a small margin of the Fed Funds Rate over inflation, but not unheard of. It is also worth noting easing cycles of the past occurred with very different fiscal and federal debt situations than the US has presently, which is clearly a determining factor in the Fed’s decision making, as I shall discuss shortly.
The Fed have made it clear they intend to take advantage of the current “easing window” afforded to them on the inflation front. As they should, particularly as inflation lead indicators are no longer unanimously pointing toward disinflation.
As I have discussed ad nauseam, upside inflation pressures will return. But that’s a story for the market to worry about as we progress through 2025, not 2024.
The Fed’s focus is now on employment
Turning our attention to the employment and jobs market front, once again, we can see an area of the economy which is somewhat supportive of rate cuts, but does not necessarily need rate cuts.
Employment data overall has by-and-large returned to normal levels as labour supply has increased over the past year. The jobs market is clearly no longer at the secularly tight levels that it was in 2022, but neither is employment data near recessionary levels.
Employment growth has slowed to pre-COVID averages and unemployment rates have moved slightly higher (though mainly through increases in the labour force rather than actual layoffs). While job openings and average weekly hours worked have also largely returned to average levels.
The same can be said of wage growth. Most measures have returned to pre-COVID levels, with the Atlanta Fed’s Wage Growth Tracker the exception. However, all remain firmly in positive territory.
Given the recent weakness in employment growth, policy rates are now firmly on the tighter side of the equation, affording the Fed scope to cut rates, even though the labour market overall remains on solid footing.
What’s more, the leading indicators of employment growth continue to suggest we are likely close to a trough, meaning the Fed will need to act quickly to cut rates as much as possible while the data allows it to do so. Again, they appear intent on doing exactly that, as evidenced by their initial 50 basis point cut.
The Fed really wants to cut
The simple fact of the matter is the Fed wants to cut rates and ease monetary policy. Even though most economic data is somewhat supportive of rate cuts, the same cannot be said of financial conditions.
The below table highlights the historical averages of several key economic and financial variables at past dovish Fed pivots versus today’s data. As we can see, on the ISM Manufacturing PMI is weaker relative to its historical mean when the Fed initially cuts rates, but all measures of financial conditions are in better shape today than their historical “Fed pivot” averages.
Cutting rates in similar economic periods in the past is not unheard of, but it is uncommon. My Fed Policy Regime Oscillator - a combination of several growth, inflation, employment and financial data points - suggests the current state of the economy and financial markets does not need easier or tighter monetary policy.
The same can now be said of inflation and economic surprises, which are now pointing to neutral monetary policy in the US (though it is clear both are favouring a dovish monetary policy stance worldwide).
The Fed are clearly showing their hand. We are likely to continues to see easier monetary policy until the data clearly no longer supports it. That time is not now.
The financial stability mandate
In addition to the dynamics discussed so far, what is likely another significant contributor to the Fed’s want to ease monetary policy is its unofficial policy mandate: financial stability.
History tells us at any sign of financial instability the Fed will step in. We obviously saw this during the GFC. We saw this during the 2019 repo crisis. And we saw this again during the regional banking crisis last year. While there is no clear financial stability crisis at present, there is some evidence we may be trending in that direction.
One important factor in assessing the stability of the financial system is looking at the level of commercial bank reserves in the system. In isolation, QT should suck reserves off bank balance sheets, but, given the huge piles of cash that remain in the Fed’s reverse repo (RRP) facility, the QT and Treasury issuance that would normally be funded via commercial bank reserves is instead largely being offset by a reduction in the RRP (as money market funds move out of RRP and into freshly minted Treasury bills). While commercial bank reserves and the RRP balance both remain at structurally higher levels thanks to the COVID related stimulus, the RRP balance is now at its lowest levels in a few years now, and as a result reserve balances have also been declining this year.
While reserve balances don’t appear to be at worrying levels, the decline over the past nine months is clear.
As reserves decline so do commercial bank cash assets, which again appear to be slowly approaching the 2023 lows that preceded the regional banking crisis.
Obviously, we are not going to have another bank run thanks to the Fed’s BTFP program and the recent rally in bonds, but a decline in bank cash assets is almost always going to be something the Fed is watching. So long as the Fed continues its QT program, much of the responsibility to fund the record levels of US Federal debt issuance falls on the private sector, particularly the commercial banks, as we can see below.
And, as foreigners are no longer funding US deficits on net at a time where the Fed is no longer a buyer of US debt, the potential stress this can cause the US private sector only increases, particularly as the RRP balance continues to fall and the Treasury is forced to issue longer-dated bonds.
Financial stability within the US bond market is always front of mind for the Fed. So, with the Treasury’s quarterly borrowing needs still in excess of $500bn, there is going to be a lot of debt securities being issued.
It is likely only going to be a matter of time before the US debt position leads to another financial stability “crisis” of some kind, so with the Fed able to wind back its QT program and lower borrowing costs while they, it makes sense.
Implications
The market is now pricing in two more rate cuts in 2024 and upward of seven to eight rate cuts by the end of next year.
This is obviously far too aggressive, as it is highly unlikely we get more than four or five additional rate cuts this easing cycle, but for now that doesn’t matter. Over the medium-term, these dynamics are very bullish.
Why? Because the Fed and most major central banks are easing monetary policy into an economic expansion. This in turn should prolong the business cycle and ease the burden on the housing market, with the latter being a particularly important cyclical driver of the economy.
And with improving economic activity and easing monetary policy, global liquidity is also on the rise.
Both dynamics should support risk assets post-election and into the early stages of 2025. While markets remain overbought versus liquidity, liquidity and financial conditions overall remain wholly supportive of the stock market at present and are only improving. This is unlikely to change until in the immediate future.
The implications of this easing cycle are likely much less favourable for bonds on the other hand. Not only have long-term yields already priced in much of the move lower in policy rates, but a robust economy coupled with a moderate outlook for inflation suggests yields are likely to trend higher from here.
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