Qualifying SP500 Levels With US Treasury Rates and Federal Reserve Low Fed Funds Policy
@BickerinBrattle
Oct 8, 2019
Fed has induced a NeoFisherianism Regime of Stagnant GDP Growth - This Era’s Form of a Recession
US Has Entered A Japanization “Lost Decade”
Term Structure of GDP Lowest Levels For Trump and Continues to Invert - 7 Years Forward GDP Growth is Now 1 3/8%
Atlanta Fed “GDPNow” Staying +/- .01% around 1.9%, Consistent With a Neo Fisherianism Regime
SP500 Supported At 2000 to 2400 (Now at 2950)
Rates are dropping again towards recent record lows, especially the longer maturities. Twenty year US Treasury now at 1.81%. The damage imposed by the Federal Reserve ease, and indications of continued ease, has eliminated support for US risky assets, with a large reduction in forward GDP. SP500 support given this forward GDP is now around 2500 and the SP500 could drop towards 2000. If this occurs prior to the election and the current Fed Reserve ease continues, this greatly reduces President Trump’s chances of reelection.
US Treasury curve (20s to 5s is useful as it does not have the heavy Fed gaming in T Bills and short intermediates) has dropped backed towards the lows of end of 2018.
Forward 7 year GDP levels are still at recent lows, down over 2.56 trillion from peak levels of 2018; and the “basis” of the 7 year forward GDP level to current “spot” GDP has dropped to a Trump administration low of 1.46 trillion from the Trump peak GDP 7 year basis of 4.58 trillion in 2018. The GDP “basis” is the GDP amount of expected growth over 7 years. The 7 year GDP basis has been cut by 70% in a very short period of time.
Therefore it is likely SP500 goes towards 2200, a drop of 600 to 750 points or about a 25% drop fm olatest level of 2950. Rates are now about 20 basis points lower along the curve than the high rates of recent days.
The elimination of support for SP500 by thrusting the US economy into a Neo Fisherianism Japanification (a “Lost Decade” status - or a classical Keynesian “pushing on a string”) is so aggressive and is likely well understood by most Fed Reserve staff, that it is almost certain the Fed is coducting an aggressive attack on Trump via policy, and seeks to eliminate his main claim to economic success, the rally in the SP500 since the November 2016 election.
It does not help Trump that the economic input he receives seems absent in monetary economics and thereby his insisting that what is required are even lower Fed Funds rate likely delights many at the Fed. This will end with President Trump holding the bag, losing in November 2020. The President is clamoring for the Federal Reserve to carry on with the only strategy that they can pursue that does Trump great harm. Irony.
The Federal Funds implied rates path is still dropping. That part of the curve that is not tied up in gaming and noise of the immediate pressure of the Fed Funds path, the curve from 5 year US Treasury to 20 year US Treasury (I use 20 years as it is the longest running and longest maturity array in the FRED data base), is still flat though rose slightly throughout 2019. But the last few sessions have started to flatten again.
(The chart of US Treasury curve 5s to 20s and the SP500 to US Treasury 20 years are given below. )
Risk premium, which has much to do with determining forward implied GDP level (current dollars - IE NGDP), has dropped from recent rise to 11 basis points to now below 10 basis points.
The risk premium and the current Fed Funds along with the likely forward path of monetary policy ease in Fed Funds, and the curve of 5 years to 20 years, has kept forward GDP levels at new low levels that are not able to support the current levels of SP500 nor has any support until 2500 and then 2200 after that. If the Fed cuts Fed Funds rate further support ratchets down accordingly to 2300 and then 1800 thereafter. The Atlanta Fed “probability tracker” of future Fed Funds shows there is a implied 100% likelihood of at least another 25 basis point cut in Fed Funds.
Atlanta Fed Market Probability Tracker
It is unlikely the SP500 finds any support or reason to advance unless President Trump figures out that the Federal Reserve is attacking his administration. Then he would insist the Federal Reserve resume normalization or at the very least stop further Fed Funds easing. Or President Trump could encourage the issuance of the ultra long US Treasurys in large amounts or even a US Consol perpetual. At least 500 billion in amount would be required. Another track President could pursue is negate the importance of the Federal Reserve now by breaking the back of debt ceiling limitation and implementing at least $1 trillion in long term public investment. Further tax cuts or easing of trade pressures on China will not be sufficient to reverse the attack by the Federal Reserve upon his administration.
Currently the SP500, given the ravage and increasing ravaging of the US forward expected GDP, via a Fed bent in having a Neo Fisherianism “Lost Decade” Federal Reserve policy, is set to see 2500 and then very likely 2200 thereafter.
If this prompts the Federal Reserve to cut Fed Funds even more aggressively than they now seem intent on doing, the support for SP500 drops to well below 2000.
Over Any Period, NGDP Economic Growth Will Be Equivalent to Long US Treasurys
A tenet in macro economics is the long US Treasury yield reflects or is equivalent (over time) to the US GDP annual growth.
Another tenet is that the long US Treasury yield is determined by the monetary policy of the Federal Reserve - the Federal Funds rate set by the Federal Reserve over the comparable time period of the long US Treasury yield.
The Fisher Rate (Fisher Equation)
Irving Fisher, described a short term risk free rate - in the US, the Federal Finds rate - derived from his “Fisher Equation” (“The Theory of Interest Rates” 1930) :
“overnight risk free rate = real national economic growth + inflation”
- or -
“Fed Funds = Real GDP + Inflation”
In the US the short term risk free rate are “Fed Funds”. The key rate for the Federal Reserve monetary policy.
The Fisher Equation describes Fed Funds as Real GDP + inflation. Real GDP is observed in a backwards manner using inflation, which is known, and the current Fed Funds an implied current real GDP is derived.
Currently, that would be the GDP “deflator” of 1.88%, as reported by the Commerce Department and with Fed Funds at 2.4%, the implied real GDP currently = 2.4% - 1.88%, or 0.52%.
While there is much noise, this Fisher Equation can “solve” for US real GDP. While the Fed is consistently raising or lowering rates real GDP change is as the market, as both are changing in the same direction.
The combined real GDP and inflation is called “Nominal GDP”, or NGDP.
The Fisher Equation solves for a “Fisher Rate” which in the US is the Federal Funds rate.
Long US Treasurys is the market expectation or prediction of a stream of Federal Funds over time. And US Treasurys have other attributes which are given more and less value at any one time which augment or diminish the Federal Funds expectations over time, to a lesser or greater degree.
Three of these values:1) US Treasurys are “risk free” given the US government backing them and are thereby a safe haven; 2) that US Treasurys provide an offset to the business cycle with an increase in value as the economy wanes - a business cycle offset insurance - 3) US Treasurys have certain specific value for large portfolios like pension funds or life insurance general accounts.
But over time the largest effect on determining rates is the expectations of Federal Funds.
The “Lost Decade” of Japan 1991 to Date (Still Ongoing)
The Federal Reserve is very powerful, now with $4 trillion of balance sheet, most of it added by the Bernanke Federal Reserve so as to add liquidity to the US economy during the recent crisis. If the US economy is in flux or stagnant, perhaps as the recovery peaks or when a recovery has yet to start, or vice versa for a recession, the Federal Reserve policy can be a self fulfilling prophecy and while policy is changed to respond in a technical manner to changes in the US economy and inflation, and during such low volatility times the Fed Funds level can set the economic status and set the inflation rate.
An example of the ability of the central bank to be a “self fulfilling prophecy” is the Bank of Japan with the low central bank funds policy for the last 16 years, which many see as the reason Japan has had a long ongoing period of stagnation, a “Lost Decade”, after the economic downturn of late 1991 and 1992. The attempt to stimulate the economy by lowering the “base rate” (the equivalent to the US Federal Funds rate) to around 0%, the Bank of Japan ended with the opposite of the sought results locking the Japanese economy into a long drawn out low and stagnant growth period now popularly called “the Lose Decade”. This was reflected in the Japanese stock market index, the Nikkei, trading 20% to 50% of the 1991 highs for most of the 1992 to 2002 decade and not approaching 1991 highs until just recently, 27 years later.
What follows is a discussion that considers this “Fisherian” error in central bank policy during a low volatility and low growth periods, of dropping the central bank rate (Fed Funds) to abnormally low rates and maintaining those low rates.
The recent sell off in SP500 may have been induced by the Federal Reserve abnormal low Fed Funds policy and has induced a US “Lost Decade”. This started started with Jeremy Powell November 28 2018 announcement that the Federal Reserve would stop “normalization” (the slow and steady raising of Federal Funds rates to a “normal”) and then dropped Federal Funds rates July 31 2019.
The risk that the US may repeat the Japanese Lost Decade error is reflected in recent sell off in SP500 levels and inability to go on to reach new highs.
If the experience of Japan is repeated in the US, SP500 may trade down to pre 2016 election levels.
## [1] "GDP"## [1] "DGS10"
## [1] "GDP"Risk Premium
A factor that qualifies the US Treasury yield curve is “risk premium”, the amount of yield required to compensate for extending one more year maturity. Since risk increases with maturity extension (the change in price of a US Treasury given a change in yield increases with maturity) this is rarely negative in value. However large, usually temporary, technical factors can distort the yield curve such that an erroneous risk premium value is calculated - especially if the shorter maturities are used being constantly stressed by Federal Reserve anticipated actions. A read of the curve is constructed in that part of the curve 5 years or more which is adjusted from other technical factors so a more useful and likely correct risk premium is derived.
The risk premium is analogous to the slope of the yield curve where period of high risk premium, say 20 basis points to 30 basis points (a basis point is 1/100 of 1 %) should over ten years of the curve have a steeper curve of 10 years times 20 basis points or 30 basis points, or a curve of 2% to 3% from Fed Funds to 10 years US Treasurys.
However there are many large technical factors affecting different areas of the curve, especially that part of the curve which is under 5 years maturity. If the curve is considered to be 5 years US Treasury to 20 years US Treasury, many of those technical factors are not impacting the curve or the 5 year out to 20 years. It is best to consider a correctly derived risk premium as a more accurate way to consider the yield curve.
Recently the risk premium was at unusually low levels, most of the drop during the time of the Yellen Fed, February 2014 to Nov 2017. The exuberance the Trump administration generated with tax policy - pro business policy and reduction in personal taxes - raised the risk premium toward 12 basis points, but since Powell stopped “normalization” of Fed Funds the risk premium stopped rising and has even started to drop. It is now under 11 basis points.
Another plotting of the risk premium, now with a reduced time period providing a closeup.
The Term Structure of Fed Funds out to 7 Years
The first 2 years of the yield curve is efficient and is based on the market best assessment of Federal Reserve monetary policy in setting the Fed Funds rate. The risk premium derived is then used to build a yield curve out to, with this model, out for 7 years. It is important to note this is not the usual yield curve of ever longing US Treasury notes but a term structure of the instantaneous Fed Funds Rate out for 7 years.
The term structure of the instantaneous rate is then considered at various times.
The term structure before the crisis (March 2007 in yellow) shows Fed Funds rates anticipated above 4% and approaching 5%.
Since then the most the Fed Funds term structure has approached pre crisis levels was during the Trump administration in March 2018 ( dotted blue), which was a considerable improvement from the lows of Dec 2012.
From March 2018 to now, the term structure is inverting and has dropped substantially.
A close up of the Fed Funds term structure during the Trump administration where all the lifting of Fed Funds anticipated from the election to the March 2018 highs has been undone so that now the term structure of anticipated Fed Funds is lower than the election and the term structure is negative.
It should be noticed that the title to these term structure of Fed Funds is called “GDP Forwards” using the above Fisher Equation where Federal Funds are equivalent to US current GDP (NGDP) growth.
First the latest term structure of instantaneous GDP (NGDP) growth rates is given from spot to 7 years.
With Term Structure of NGDP Growth, Expected GDP Level in 7 Years Derived
The term structure of GDP (NGDP) growth per year is used to derive an expected GDP level in 7 years.
This is rich in information regarding market expectations and can be used to qualify current key US Treasury rates and the SP500. While it is noisy, the SP500 levels and changes in levels does reflect the general state of the US economy expected.
The GDP level in 7 years is derived by compounding out the term structure of NGDP growth for each date.
The 7 years forward GDP level is then compared to current GDP.
The expected growth in 7 years for GDP as well as the level expected in 7 years for GDP showed strong growth since the election but then reversed and plunged from the end of 4th Q 2018 to today.
While SP500 traded down in December 2018 as GDP forward growth and level turned down, SP500 recovered and then has traded down a few times with the the current trade off the most recent. Most use the developments with China to explain these turns.
Forward GDP is steady in direction and has turned down only from 4th quarter 2018 onward and has been steady and large in that downturn since. It does not seem to be responding to China news.
What is consistent with this downturn in forward GDP growth and level is the significant change in Federal Reserve policy from a steady (though some think too slow) normalization if Fed Funds to an announced end of normalization as of the end of 2018 and then a drop in Fed Funds on the July 31 2019 FOMC meeting.
The drop in forward expected GDP level has not been changed, given the risk premium and various forward rates being unchanged, with the recent sudden backup in rates with the US Treasury 20 year backing to 2% from recent lows of 1.77%.
The “Basis” of 7 Years Forward GDP to Current GDP
The 7 Years forward GDP is netted against current GDP and a basis is calculated. This is the level (in billions here) of expected growth in GDP over the next 7 years.
The basis is in free fall, diving from peak level of 4.58 trillion, only recently achieved in 2018 to the current basis now at 1.45 trillion, a change of 3.13 trillion from peak to now - a calamity.
Error to Use Current GDP to Qualify the SP500
The US economy is depicted by current GDP as reported every 3 months by the Department of Commerce. The US economy is unusually steady in growth over the years so most see current SP500 levels as reflecting the current US economy. as shown. With this view the recent sell off in SP500, ostensibly from the China trade policy negotiations, indicated that while down the basic trend is intact. And with the recent rise in SP500 back towards 3000 would seem to indicate a return back to the bull market trend.
The US Treasury Curve Flattens
While the China news was given the blame for the most recent sell-off in SP500, the swift and large flattening of the US Treasury curve - the difference between the longer maturity US Treasury less a shorter maturity US Treasury - alarmed the market. Many commented that when the US Treasury curve “inverts”, with shorter maturity used yield larger than the longer maturity, a recession will surely follow. However this was rustic “folk wisdom” and not useful in really qualifying SP500 levels as the recent rise in SP500 has shown.
But the US Treasury curve is by definition is forward looking; and as SP500 is a forward looking value the curve might be better matched “apples to apples” to qualify SP500 levels.
The current levels of US Treasury yield is at record low yield and the Federal Reserve has reversed policy and started to lower Federal Funds rates, and the “forward guidance” policy of the Fed is stated to give a dependable depiction of forward Fed Funds path. That means that the noise and mispricing in current low US Treasury levels is large.
The curve that is more useful and not influenced, perhaps, by this noise is the longer curve from US Treasury 5 years to US Treasury 20 years. This has dramatically flattened but has steepened a small amount from lows in December 2018. This indicates the current concern of the curve is misplaced and that the curve is showing small increase of the risk of inflation as the Federal Reserve ceases tightening and eases.
Another approach is to use probability density curves as priced in options on Eurodollar 3 month LIBOR futures. A good summary of this approach is from Bauer and Mertens of the San Francisco Federal Reserve Zero Lower Bound Risk according to Option Prices . Howevere Bauer and Mertens only go out as far as the Eurodollar options in 2021, or 2 years forward and there is still alot of noise present. However they do show it is a better estimate of likely probability of a slowdown in GDP than the curve, as they depict Image 3 Evolution of downside risk since January 2018.
The “Maturity” of SP500
The focus on the curve was perhaps immediately misplaced, but considering a longer forward looking data to qualify SP500 rather than current GDP level is correct. And the scatter plot of SP500 to the curve concerns.
SP500 has a maturity of about 8 to 15 years, bond math calls this maturity “duration”.
The 7 Years Forward GDP Level Does Not Support Current SP500 Levels
A Siginficant Sell Off In SP500 Likely to Occur
The better forward longer maturity value to qualify the SP500, far better than current GDP, is the above 7 years forward GDP level value. This is an “apples to apples” match and as the SP500 does reflect the US economy, but in the future, this comparison of 7 years forward GDP to SP500 is alarming.
The support of the SP500 is absent at current SP500 levels and the 7 years forward GDP level suggests the SP500 could trade to 2500 before finding support from the US economy status.
The “Basis” of 7 Years Forward GDP to Current GDP
The 7 years forward GDP level difference to current GDP - a " GDP basis" - gives even more concern. The SP500 level has an implicit growth rate of the US economy. It makes sense to compare the GDP basis to current SP500 levels.
This suggests that SP500 will not find support, if it is discounting a growth expected over the next 7 years, until 2000 to 2200 level is reached.
The Federal Reserve Is Midstream of a Most Significant Error in Monetary Policy
Is This Error Deliberate or Honestly Arrived Upon Via Policy Mishap?
By accepting that SP500 does reflect the expectations for the US economy, and accepting the Fisher Equation thesis - that the Fed Funds rate is current real GDP growth rate plus inflation, the Fisher Rate/Fed Funds rate can be derived into the future and is then a useful qualifier of current SP500 levels.
The US 22 trillion dollar GDP will be too large for even the Federal Reserve “contain”, and the general economy will determine the US growth along with the US government fiscal policy.
But until meaningful US fiscal policy begins, the Federal Reserve will determine US NGDP growth - whether or not the Federal Reserve realizes.
It is reasonable to assume that all the above is well known by the Federal Reserve - or at least a significant “core” of the staffers and Governors.
That would imply that inducing this Fisherian stagnant growth is not an error, but a deliberate strategy for a specific political outcome. If that is the case the first signs of this possibly induced “error”" was when Yellen reversed the Bernanke path to normalization. From 2014 onward, Yellen has spoken adamantly that the role of the Fed is to promote social good via raising employment not only in general but to the usually disenfranchised, and for the Fed to be in close synchronization with other international central banks and monetary authorities. For the Federal Reserve to be more powerful in such social policy, then the focus on monetary policy restrains, and prevents the Federal Reserve synchronization with international peers. So the Fed has dropped rates accepting the stagnant growth, accepting a less than optimal GDP as it will “reach” certain disadvantaged parts of society.
The Federal Reserve cannot make a qualifying difference for progressive good if it solely focus on the monetary policy as outlined in the Federal Reserve Act and the Humphrey-Hawkins Full Employment Act. It cannot abide by a strictly economic nationalism role, no matter the law. So it ignores law and sets out on a self defined strategic progressive objective.
That such a stagnant economic outcome will interfere with President Trump’s re-election in 2020 is an added benefit. And an SP500 dropping towards 2000 to 2200 will actually be a necessary ending of a possibly dangerous financial bubble.
That none of the above possible Federal Reserve strategic goals is not written into any of the mandate laws the Federal Reserve operates under does not seem to bother the Federal Reserve at this time.
End