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The US Economy – Is It Really That Bad?

The following are slightly-modified extracts from recent commentary that appeared at The Speculative Investor web site.

Interest Rates and the US Economy

During the first half of May 2000, Wall St firms were busily raising their estimates for official interest rates. The consensus expectation at the time was that the Fed would continue hiking rates throughout the second half of the year, adding 150 basis points to the Fed Funds Rate (FFR) by January 2001 (taking the FFR to 7.5%). We thought they were going to be proven wrong, and in the May-08 and May-15 Weekly Market Updates stated that the Fed would be finished raising rates by mid-year and that the FFR would not exceed 6.75% (6.5% turned out to be the actual maximum). Our reasoning, at the time, was that evidence of an economic slowdown would soon arrive and that this evidence, combined with the upcoming elections, would mean there would be no rate hikes beyond June 2000.

In contrast to the fear of unsustainably-high economic growth that prevailed last May, many analysts have now come around to the view that the US economy is about to plunge into an abyss. The consensus expectation is now for a series of rate cuts that begins almost immediately and reduces the FFR by at least 100 basis points (bp) during the first half of 2001. Some analysts are even suggesting that the Fed will wipe-out the total 175bp of rate increases that have occurred since the tightening cycle began June 1999. The main bones of contention, at this time, seem to be: a) Will the Fed wait until its late-January meeting to cut rates, or will it do an inter-meeting cut? And b) Will the January cut be 25bp or 50bp?

As we did last May, we are going to disagree with the consensus. The following charts explain why.

The above charts show the Morgan Stanley Cyclicals Index (an index of economically-sensitive stocks) and two individual stocks (Alcoa and International Paper) that are positively correlated with economic growth. The index and the two stocks began sharp down-trends early this year, telling anyone who was listening that economic growth had peaked and a significant slowdown was in the works. These charts bottomed in mid-October, at which point upward trends commenced.

Further to the above, it looks to us like rumours of the US economy's death have been greatly exaggerated. Data pointing towards a slowdown will probably continue to filter through for the next month or two, after which some signs of strength should appear. By April/May, the economy is likely to seem quite robust. We don't think this is the start of a new cycle, but rather the last gasp of an old cycle.

The Fed will almost certainly cut rates at the January FOMC Meeting and possibly at the ensuing March meeting, but the total reduction in official rates over the next 9 months is not likely to exceed 50bp. In contrast to the expected lowering of official short-term interest rates, long-term (market) interest rates (the yields on T-Bonds and T-Notes) should be much higher, by March of 2001, than they are today. In fact, the above charts do a nice job of supporting our view that bonds are very close to a major top (bond yields are very close to a major bottom).

Monetary Madness

During the 9-week period from Oct-25 to Dec-27 Reserve Bank credit increased by $24.8B, or at an annualised growth rate of 25.6%. Additions to Reserve Bank credit support an increase in lending by the private banks. So, has the Fed already begun to re-liquefy the system?

The short answer is no. The Fed is simply supplying funds in order to maintain a target interest rate. Once a target has been set for the Fed Funds Rate (FFR - the rate at which banks charge each other for overnight money), the actual rate is kept near the target rate by adding or removing funds via the Fed's Open Market Operations. For example, the target FRR is currently 6.5%. If the Fed sees the FFR begin to move higher than 6.5% it will provide the banking system with additional reserves by purchasing securities (usually US Government debt instruments) from the banks. It will continue to add reserves (in exchange for securities) until the FFR drops back to the 6.5% target. Similarly, if the FFR drops below 6.5% the Fed will remove reserves from the banking system by selling securities to the banks. The whole system is based on controlling the price of money, not the supply of money. The Fed effectively has no choice other than to make whatever changes are necessary to Reserve Bank credit in order to keep the FFR (the price of short-term money) near the targeted rate. This is one of the reasons we ended up with a debt bubble - the price of money was fixed at an unreasonably low level for several years (significantly lower than the natural market rate), thus causing an explosion in the supply of money.

If the Fed wanted to boost liquidity, rather than simply maintain a target interest rate, it would need to either reduce the FFR (as it almost certainly will do by the end of January) or increase Reserve Bank credit beyond what was needed to keep the FFR near its target (as it did during the lead-up to the Y2K transition). At this stage, however, the Fed has made no visible attempt to increase liquidity.

Regardless of the Fed's intentions, the fact remains that the sum of $24.8B in additional Reserve Bank credit has been required over the past 2 months in order to keep the FFR from rising above the 6.5% target. In other words, the demand for money remains high. It is also worth noting that the total supply of money (M3) increased by $104B during the 4-weeks ended Dec-18. This tells us that the stock market bubble may be dead, but the underlying debt bubble is still very much alive and is supporting the prices of other assets such as real estate.

The recent surge in money-supply growth and the strength in cyclical stocks mentioned above suggest that the US economy will surprise on the upside during the first half of 2001. As outlined in a previous article entitled "The 2001-2002 Recession", our view for the US economy over the coming 2 years is not exactly sanguine. However, real economic weakness is unlikely to materialise until the second half of the new-year.

Steve Saville
Hong Kong

1 January 2001

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