A Fresh Look at Monetary Policy (Q&A)

By Deron T. McCoy, CFA®, CFP®, CAIA®
Chief Investment Officer

When will the Fed lift rates?
We believe it could be in 2024 or later.

How did we arrive at this forecast?

• There are several ways that we can come to the same conclusion. First, we can let history be a guide. After the 1990 and 2001 recessions, it took about 2.5 years after the end of the recession for the Fed to move rates higher. The Great Recession was larger than the previous two recessions, so it took longer to raise rates—that time around 6.5 years. If the recession were to end in Q4, then 2-3 years would take us out to Q1-Q2 of 2023. This GDP decline is much more severe than the Great Recession, so perhaps it will be longer—but not quite ready to make a 2027 type of forecast.
• Another way to look at it is through the dual mandate lens. A material move upward in rates would only occur after a material move up in inflation in conjunction with a material move downward in unemployment. But with falling wages, falling rents, and negative energy prices all pointing toward a deflationary environment combined with double-digit unemployment—monetary policy will be benign for a very long time
• Finally, we can simply look to the yield curve. I would say a move in the Fed Funds will be put off until the Ten-Year Treasury yield is north of 2.00% which again—appears to be a long way off.

Will the Fed increase emergency actions?
With the unprecedented action already taken, it is hard not to say that more is coming as it is easy to assume that they will throw anything and everything.

What are we expecting the fed to do?
The Fed/Treasury are artificially holding up markets until the recovery/economy can take over and lift it higher (think of it as a bridge over a deep valley). The Fed expanded from Investment-Grade (IG) corporate debt to High Yield corporate debt. Perhaps they will expand the mortgage purchases from investment grade (Agency) to High Yield (Non-agency). Unlike the last recession, the US Government very much wants to help homeowners so that seems like a logical step.

What shape will a recovery take?

• Some forecasters use V or U shaped. But from our seat, it’s certainly not a ‘V’ since the initial downdraft was not a sloping line but a near vertical drop! Consider that during the Great Recession the economy contracted 4%. Today, it is estimated that our economy will contract 7% in Q2 which is nearly twice the level of decline than a decade ago. Furthermore, in the first month of the crisis, we lost 21 million jobs—and to put that number into perspective—over the last decade which was the largest expansion ever, we created 21 million jobs. So we essentially lost 10 years of expansion in four weeks.
• Before we get the ultimate expansion, which might be delayed until we get a vaccine, we will bounce along the bottom for a while. I do not think it’s hard to imagine that consumers/ corporations will be a bit thriftier than they were in January 2020. That is not a hard stretch. So, the recovery is not going to be V-like either.
• Then what will the final rebound look like? We will know the answer to this perhaps by June 30^th. The patient (US economy) was put into a coma (lockdown) in order to treat the virus. The longer the patient is in a coma, the more the muscles atrophy. To get these jobs back, Congress approved the Paycheck Protection Program (PPP) so that our economy doesn’t atrophy with permanent loss of use. We will know by June 30^th whether these jobs come off unemployment as that is what’s written into law for the PPP loans to be forgiven. In terms of shape, perhaps a ‘U’, or a Nike swoosh, or a deep cup with a flat handle about 85% of the way up.

Will it lead to longer-term damage (elevated unemployment, deflation, destroyed demand, etc.)?

• I think some sort of longer-term damage is a given. I believe there will be lingering spending problems, lingering social distancing concerns. We just won’t be getting back to 2019 all that quickly. Don’t get me wrong, we will show up and spend again, just at a reduced level.
• Speaking of a reduced level, corporations and households will hold higher levels of savings which is the prudent step to take but in aggregate reduces investment and economic activity.
• These types of events can change society, but we feel the nature of this event will accelerate recent themes instead of changing recent themes. The move from brick and mortar to online only gets accelerated going forward. We feel retail that was already stressed (department stores, gyms, mall-based restaurants, etc.) only gets worse as well as the owners of the underlying real estate. As such, the natural rate of unemployment may be a tick higher than the last cycle.
• Another 2019 theme might get accelerated here as well, namely our relationship with China. And this time it might not be just the US on that island as I can imagine a scenario where Italy, France, Germany, not to mention Boris Johnson of the UK, start to back away from their relationship with China as well. We are still in the early innings here but the global supply chain might receive the biggest wrecking ball of all.

 

Although the information has been gathered from sources believed to be reliable, it cannot be guaranteed. The information contained herein reflects the firm’s views and is subject to change at any time without notice. Views expressed in this article may not reflect the views of Royal Alliance Associates, Inc. Securities offered through Royal Alliance Associates, Inc. member FINRA/SIPC. Investment advisory services offered through SEIA, LLC, 2121 Avenue of the Stars, Suite 1600, Los Angeles, CA 90067, (310) 712-2323. Royal Alliance Associates, Inc. is separately owned and other entities and/or marketing names, products or services referenced here are independent of Royal Alliance Associates, Inc.

---