This Fire Burns
What we're seeing now I think we can describe as a soft landing and my hope is that it will continue – Janet Yellen
On January 8, 1835, a pivotal event unfolded in the economic history of the United States — the nation celebrated a unique and meaningful achievement: the complete elimination of its national debt. At that time, the US government found itself in the unprecedented position of being debt-free, marking a distinct moment that showcased the fiscal policies and economic philosophies of President Andrew Jackson and his administration.
The milestone of a zero-dollar national debt was the culmination of deliberate efforts and policies initiated by President Jackson. Renowned for his fiscal conservatism and skepticism of centralized banking, Jackson was determined to reduce the influence of financial institutions and significantly eliminate the national debt. His administration pursued aggressive measures to achieve this goal, which included withdrawing government funds from the Second Bank of the United States.
This endeavor, known as the Bank War, involved a series of financial and political conflicts. Under the leadership of Secretary of the Treasury Roger B. Taney, the administration sought to disentangle the federal government from the central bank, viewing it as a threat to the nation's economic sovereignty. The move was not without controversy and generated intense debates over the role of banks and the federal government in shaping the economic landscape.
By January 8, 1835, the concerted efforts of Jackson's administration had succeeded — the entire national debt was paid off, and the United States achieved a rare state of financial freedom. The occasion was celebrated by those who supported Jackson's economic policies, which emphasized limited government intervention in financial matters. The absence of a national debt symbolized a vision of an economically independent nation with reduced reliance on external financial institutions.
However, this debt-free status proved to be short-lived. The economic landscape and policy debates shifted, and subsequent administrations faced new challenges that led to the re-accumulation of the national debt, especially during war and economic crises.
Despite its temporary nature, the period in 1835 when the United States was debt-free holds a significant place in the annals of American economic history. It reflects a distinct chapter where the nation grappled with questions of fiscal responsibility, the role of banks, and the complexities of maintaining financial independence in a rapidly changing world.
The achievement of a zero-dollar national debt in 1835 starkly contrasts the perspectives held by many economists today. Keynesian economists mostly argue that reducing the debt is counterproductive for an economy as 'austerity' hinders economic growth and people’s well-being. Nowadays, many modern-day Keynesians even drop the notion that John Maynard Keynes originally made, namely that governments should reduce their debt burden during boom times to have the ammunition to fight a downturn.
Then, there are MMT economists who argue that government debt equals private sector surpluses and, as a result, paying down the debt would stifle economic growth and diminish all private sector savings. According to them, governments of countries that finance their deficits in their domestic currency can sustain deficits without dire consequences and thus should spend to boost the economy.
Summed up, the present-day economic landscape has departed significantly from the fiscal policies championed by President Jackson in the 1830s. Over the course of the last 50 years, the national debt has reached unprecedented levels, fueled by factors such as ongoing wars, economic recessions, and substantial government expenditures. The departure from Jackson's goal of a debt-free nation underscores the evolving nature of economic philosophies and the challenges posed by modern economic complexities.
The more things change, the more they stay the same, one says, and the discussion about debt, economic growth, inflation, and taxes was and still is at the center of economic debates among proponents of various schools of thought.
As we conclude the second trading week of the year, the developments in financial markets have roughly aligned with my expectations, though stock markets in Europe and the US have not surged to higher highs. While I still anticipate that this could occur in the coming weeks, the bond market is in the driver's seat for now.
In my last post on December 15, I wrote that
…the economy may fare better than initially expected at the start of the year, potentially pushing the US 10-year yield back up close to 5%.
Bonds continued their sell-off, initiated during the last week of 2023, driven by consistently softer-than-expected European inflation data and stronger-than-expected US economic data. This appears to be a bit of a headwind for the stock market, preventing it from reaching further highs.
The recent rally in European and US stocks halted mid-December and has trended sideways since then. Economic data suggests that market participants may have been ahead of themselves with their rate-cut expectations for the Federal Reserve. However, the fact that prices have trended sideways might indicate that some caution is warranted, but it doesn't necessarily support an imminent sell-off, as some people might think.
While the short-term outlook presents some potential warning signs, the medium- and long-term perspectives remain bullish. As long as the market remains resilient amidst the stronger-than-expected data, the ongoing disinflation and eventual cooling in the future will serve as tailwinds for stock prices.
Indeed, it appears that the US economy is currently undergoing a soft landing, and those who predicted such an outcome are already celebrating victories. President Biden's top economic adviser, Lael Brainard, informed journalists that the likelihood of a soft landing has significantly increased.
Some, including Nobel laureate Paul Krugman, go so far as to assert that the rate hikes weren't necessary to curb inflation:
Team Transitory predicted a positive supply shock as conditions normalized, and that happened – much later than predicted, but then very fast… yes, the Fed raised rates, but not sign of the Mechanism (unemployment) by which rate hikes are supposed to reduce inflation.
Furthermore, Krugman, who authored a recent piece in the New York Times titled "Beware Economists Who Won’t Admit They Were Wrong," has already hedged his assertion that the US economy successfully achieved a soft landing:
Now, I didn’t yell at the Fed for raising rates; we didn’t know this would happen and hiking rates looked safer than not. And rate hikes haven’t caused a recession, at least so far…
Using this argument ensures that he will be proven right, nevertheless. If there’s no recession, he’s right; if there is one, he’s right because it’s all the Fed’s fault. The problem here is that it totally neglects the fact that a recession would result from the misallocation of capital and resources during the post-pandemic boom induced by low interest rates.
Nevertheless, the claim that declining inflation needs a rise in unemployment has always misinterpreted the Phillips Curve. After all, the original Phillips Curve, a finding of William Housego Phillips, simply says that wages are higher when unemployment is low, which is quite logical given that more unemployment means more worker supply. But I’ll get back to that a little bit later.
First, let’s look at some of the latest economic data. To echo investor Jason Shapiro, in the marketplace, it’s not about being right or wrong; it’s about making money. Market participants these days pay a lot of attention to various headline numbers and often don’t really bother to dig into the details. Last Friday’s Nonfarm Payrolls were another example of that.
On the surface, the data looked quite compelling. In December, the US economy added 216,000 more jobs, more than expected. The unemployment rate fell by 0.1 percentage point, and average hourly earnings grew 4.1% year-over-year, slightly better than expected. Therefore, it isn’t surprising that these numbers sent stocks and yields soaring, lowering rate-cut expectations.
The initial numbers drive markets, and hardly anyone bothers to look beyond the headlines. Nevertheless, if one looks under the surface, the data doesn’t look compelling. Prior months were revised down again, reducing job growth to 109,000 if downward revisions are included. The duration of unemployment also continued to tick higher, which usually happens when the labor market weakens. The coming months will tell whether the celebrations of a soft landing will turn out to be premature.
On the other hand, economic growth in the US seems poised to remain quite solid. The Atlanta Fed’s GDP Nowcast forecasts that the US economy grew about 2.21% annually in the fourth quarter. However, the costs for that level of economic growth are relatively high when one considers that the US government ran a deficit of 7.7% of GDP in 2023. In the third quarter, the deficit rose by $621.5 billion, while the economy grew by $547.1 billion nominally. That means the return for one additional dollar spent by the US government created about 88 cents of growth. Given the law of marginal utility, the return will become smaller if the deficit is increased further down the road.
For now, however, the US economy remains in "Goldilocks" mode, which serves as a tailwind for equity markets. Therefore, one can assume that the current market sentiment will benefit the stock market, and thus, it’s not the time to fight the rally. The current quarter could push equity markets to new all-time highs while keeping yields high as well, as market participants cut back on rate-cut expectations. Furthermore, the ISM employment index on Friday also pointed to a weakening labor market.
Another aspect that suggests that the economy is cooling is credit growth, which continues to decelerate. On a year-over-year basis, the slowing suggests two things: continuing disinflation and possibly an economic downturn later in the year. The slowdown of bank credit is consistent with levels reached before or after previous recessions such as 1990, 2000, 2008, or 2020.
While every government official in the United States is celebrating that the economy is achieving a soft landing, the situation in Europe is far grimmer. Germany has already entered a recession in the second half of 2023, and somehow, it doesn’t look as if things could improve soon, although the ECB projects that the economy will slightly improve in 2024 and 2025 before it stabilizes in 2026.
German economic production continues to trend lower, especially in energy-intensive sectors, where production is now lower than during the COVID-19 shock. This might be a primary factor why the total load on German public power plants fell by 5.3% in 2023, as Reuters reported.
From this perspective, Germany’s economic minister, Robert Habeck, probably shouldn’t be too excited about it. Overall, Germany’s industrial production has declined for six consecutive months now. It last fell that long during the Great Financial Crisis of 2008.
Germany is also grappling with domestic political turmoil stemming from the latest budget proposal, where the government plans to end tax deductions for diesel for farmers. Consequently, farmers have started blocking roads all over Germany to rally towards Berlin for a more substantial protest next week.
In particular, German businesses are expressing dissatisfaction with the economic policies of the current government, as reported by Reuters:
German wholesalers expect their revenues to fall 2% in nominal terms this year, continuing a downward trajectory after a 3.75% decline last year, the BGA lobby group said on Wednesday, saying sentiment in Europe's biggest economy was "on the floor".
Yet, the geopolitical difficulties arising from the war in Russia are not the only challenge for the European industrial sector; another issue is that the ECB’s monetary policy remains restrictive, and policymakers haven’t publicly signaled that they’re considering rate cuts in the near future.
However, with such a dire economic outlook for the Eurozone economy, it’s hard to envision that the ECB will be able to maintain a restrictive stance for much longer. Demand for bank lending has already deteriorated, posing a problem for European businesses as they heavily rely on bank lending. Chart 3 by Longview Economics shows that weak loan demand comes from all companies.
On the other hand, one might argue that the current state of the Eurozone economy might justify the ECB’s point of view that it’s premature to talk about rate cuts. Recently, the market has scaled back on rate cut expectations, and yields have started to rise again, also partially driven by continuously resilient US data.
However, given the economic weakness in the Eurozone, while the US economy is still going strong, the euro continues to look overvalued against the dollar. The upward move in Eurozone government bond yields might continue in the short term. Still, if the ECB is pivoting before the Fed, which isn’t what market participants expect, the euro will devalue against the dollar, and EUR/USD will move towards parity, which is what I anticipate.
Finally, let’s turn to the current tensions in the Middle East, where shipping costs have sharply risen due to the attacks of the Houthis in the Red Sea. As a result, shipping and oil companies suspended transit through the Red Sea, one of the most important maritime trade routes.
There are warnings that the rise in shipping costs will result in higher consumer price inflation, as shipping companies now need to take an alternative route at a higher cost. But just like higher wage growth doesn’t necessarily mean higher inflation, the same is true regarding shipping costs.
If the price of one good increases, then prices for other goods will decrease because economic actors now have to cut back on other things to consume as many goods that were shipped as before. Another solution would be for consumers to cut back on the consumption of shipped goods, which also would bring prices back down and, as a result, won’t drive the general price level higher.
Admittedly, there may be some increases in measured consumer price inflation in the short term because businesses raise prices to cover their increased shipping costs. However, this will likely prove unsustainable as demand adjusts to the new situation.
The situation in the Red Sea might lead to a short-term increase in consumer price inflation, but as the demand side adjusts, the general price level will likely decrease again. Without a growing supply of money units, the situation would be unstable. Additionally, even if one assumes that rising shipping costs will lead to higher inflation, the current rise in shipping rates is pretty consistent with consumer price inflation around the 2% level.
Therefore, in the short term, I would project that yields might continue to countermove higher before they fall again as economic problems emerge and inflation fails to pick up sustainably. Meanwhile, the stock market will likely persist in its current Goldilocks scenario.
Even through the darkest days
This fire burns always
This fire burns alwaysKillswitch Engage – This Fire Burns
Have a great weekend!
Fabian Wintersberger
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(Please note that all posts reflect my personal opinions and do not represent the views of any individuals, institutions, or organizations I may or may not be professionally or personally affiliated with. They do not constitute investment advice, and my perspective may change in response to evolving facts.)