‘Connecting the dots. When we look at economic and market data, there are 20 different stories and they go in all kinds of directions. How is all this connected? The economics textbook can provide a framework for thinking about what’s going on. The job of economists is to communicate this in an intuitive way,” said Torsten Slok,  one of the most influential economists on Wall Street.

Approaching the end of the first quarter of 2024, it is worth connecting the dots in the economy to get an intuitive sense of what is happening.

First, what have been the effects of the aggressive rate hikes we have seen across the global economy, outside of China, since 2022?

In the US, things have not transpired as expected at all; the consensus view in 2022 was that an inventory-led recession would be almost unavoidable to quash post-Covid inflation. The economy has, however, shown robust GDP growth figures. 

Economists could not have been more wrong.

Instead, the effects have been largely distributional. The most indebted consumers have battled, with defaults on credit card debt and auto loans growing at a faster pace than even during the pandemic. 

Top-end consumers, who carry low debt and are asset-rich, have been relatively unaffected, continuing to spend on Hermès handbags and tickets to see Taylor Swift.

In the US, this inequality has become extreme. 

According to the St Louis Fed, all the excess savings and growth in consumer spending comes from the top 20% of income earners who account for over 50% of consumer spending.

Simply put, higher rates have meant a hard landing for 40% of the US population. 

The second dot to connect is the easing of financial conditions due to the extremely strong start to the year across risk assets. 

The fundamental factor driving this was the much-heralded “Fed pivot” announced at the end of last year, signalling that the US had reached peak interest rates. 

This was an explicit bull indicator to investors.

Since then, global stock markets are up 25%, investment grade and high-yield bond yields are down (bond prices move inversely to yields), house prices are up 6%, bitcoin has reached all-time highs, and even M&A and IPO activity is up.

Everything rocketed after the Fed signalled that rates were going lower.

Furthermore, there was the entirely exogenous effect of the AI boom in stocks, with chipmaker Nvidia now the second most valuable company in the world.

Whether this bubble has been a cause in itself or is simply a result of easier liquidity remains to be seen.

Rather than any discernible improvement in the real economy, it has been this easing in financial conditions, or “wealth effect”, that has driven consumer behaviour in the US.

The third dot is what is now transpiring as a result of this bipolar economy.

Between the lower tier of indebted consumers battling higher interest rates and a free-spending segment of savers with financial assets benefiting from easier financial conditions, there are signs of sticky if not reaccelerating inflation.

The Fed’s target CPI (consumer price index) is 2%. It is currently 3%, and worryingly, both the three-month and six-month annualised change in core CPI (CPI without volatile fuel and food prices) shows inflation starting to go up again. This is largely because of the strong tailwind coming from easier financial conditions.

By explicitly communicating the target of two interest rate cuts in 2024, has the Fed essentially talked itself out of this being able to happen?

We are therefore facing what, in 2022 and 2023, was often described as a nightmare situation for the Fed; a “real economy”, especially among more indebted consumers, slowing down alongside a sticky if not reaccelerating inflation rate above the target level.

This surely means the Fed will find it very hard to cut rates in 2024, even if – outside the highest echelons of consumers – the economy is battling.

While the market has bought into the Fed forecast of two rate cuts in 2024, there are two potential bumps on the road ahead. 

One risk is that rates stay higher for longer because the final mile of getting inflation down to its target level is much harder than forecast. As the Fed continues to withdraw liquidity and keeps interest rates at higher levels, more and more balance sheets will be impacted.

If the Fed also continues with liquidity-absorbing quantitative tightening, and reverse repo balances go down to zero in May and June, this poses clear risks to the plumbing of the financial system – in particular regional banks and commercial real estate.

This could presage a banking crisis, economic slowdown and even a recession towards the end of this year.

An alternative risk is that we begin to see an acceleration of growth that is so strong that the Fed has to do the opposite of what it has signalled and hike interest rates again. 

As Slok says: “That’s not my base case at all, but it would be the mother of all pain trades. No one is preparing for that risk.” DM