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April 01, 2019

Central Banks Are Getting It Wrong About The Next Recession

Central banks overwhelmingly focus on targeting inflation. Yet more attention to the financial cycle by central banks could go a long way to extending the business cycle.

As a case in point, the U.S. Federal Reserve Bank (“Fed”) chief, Jerome Powell, surprised markets with his ultra-dovish stance for the second time in as many meetings. Powell expects no more rate increases this year, and will end the balance sheet wind down by September. He stressed that inflation was tame, and modestly downgraded growth expectations.

Equity markets jumped in response to the news, while Treasury yields dropped, as investors assume an end to Fed tightening and rate cuts in 2019.

This view is driving the current Treasury yield curve inversion, as the 3- month Treasury rate exceeds the 10- year rate.  Normally that’s a reliable harbinger of a recession, albeit with a significant lag. However, it can also be interpreted as an emphatic sign that investors are expecting the Fed will cut interest rates.

The problem for Powell is that while inflation remains subdued, growth still looks solid and unemployment is at a 50-year low.

US Core PCE Inflation

Source: Federal Reserve Bank of St. Louis. Core inflation excludes food and energy.

U.S. core PCE inflation Sun Life using data from Federal Reserve Bank of St. Louis

Inflation Is Losing Its Bite

Most central banks believe rigorous inflation management is paramount to controlling the business cycle and supporting growth. After all, targeting inflation is embedded in their mandate. In contrast, the Bank of International Settlements (“BIS”), the global central bank coordinator, has presented compelling research that this blind allegiance may be outdated.

Relying on 140 years of data across 38 countries, the BIS found weak links between growth and inflation. Instead, changes in equity and house prices were better predictors of growth.

Since the 1980s, financial cycles have also grown in length and intensity. That’s when the financial system started to deregulate, making funding and risk-taking easier.

Coincidently, that’s also about the time that inflation started to lose its bite. 

Financial and Business Cycles in the United States

1 The financial cycle as measured by frequency-based (bandpass) filters capturing medium-term cycles in real credit, the credit-to-GDP ratio and real house prices.

2 The business cycle as measured by a frequency-based (bandpass) filter capturing fluctuations in real GDP over a period from one to eight years.

Source: Drehmann et all (2012 updated), “Characterizing the financial cycle: don’t lose sight of the medium term”, BIS Working Paper

The Financial and Business Cycle SUN LIFE USING DATA FROM BIS

Are We In A New Regime?

Central banks’ credibility has helped to anchor inflation expectations, while globalization’s deflationary effects have helped to contain it. Even after a decade of overwhelming global quantitative easing (“QE”), inflation has not become a threat.

So if inflation is well-contained and unresponsive to QE, then continued accommodation may instead be fueling asset bubbles which central banks don’t formally consider in their monitoring. That means they are unlikely to react to a financial cycle bust until it's too late and in route to derailing growth.

History shows that ignoring the financial cycle can be lethal.

We’ve seen four recessions over the last forty years. Only one of those was caused by the Fed, when it hiked interest rates from 9.6% to 19.1% in 1980, leading up to the 1981-82 recession.

The three following recessions were either ignited or amplified by asset bubble disruptions.

A record number of savings and loan institutions failed as imprudent real estate lending sparked the 1990-1991 crisis. The dot-com bubble of the late 1990s and early 2000s ended when valuations snapped. And the implosion of subprime mortgages in 2007 heralded the worst recession since the depression.

BBBs: The Spark That Ignites The Wildfire?

Many investors fear bloated U.S. corporate debt could usher in the next downturn.

Investment-grade debt, for instance, has almost doubled since the financial crisis. Telecom and media companies borrowed to consolidate their industries, banks increased debt to fortify their balance sheets and large technology companies borrowed domestically rather than repatriate overseas profits.

Buybacks hit record highs over the past several years, with some of that funded through debt. An increasing number of companies chose to issue public corporate debt for the first time rather than continue to rely on banks. That helped diversify funding sources as the credit freeze post-crisis reminded them that banks can quickly lose their appetite to lend.

Some investors are concerned that overall debt quality has dropped, with half the broad market rated BBB. They fear a downturn could lead to an increasing number of companies cutting investment and hiring as profits decline and they struggle to meet debt payments.

However, much of the merger and acquisition financing has been locked in long-term at low rates. That reduces rollover risk. Also, many BBB issuers are non-cyclical companies that generate stable cash flows.

Across critical metrics, such as interest coverage and debt-to-free cash flow, the debt burden looks manageable. Certainly, individual companies can stumble but there is no glaring weakness or systematic concentrations of risk right now.

The one wild card in anticipating the depth of the next credit cycle is projecting how aggressive credit rating agencies will be in downgrading issuers that hit speed bumps rather than rating them “through the cycle.”

Perhaps Powell is paying more attention to the financial cycle than his predecessors. He is the first Fed chief to publish a Financial Stability Report which includes a synopsis of major asset classes, emphasizing risk and valuation concerns.

However, his mandate – and those of most central banks – is focused squarely on inflation. Redirecting some of that diligence to arresting any asset froth could extend the business cycle, but for now it seems like a side bar.

This material contains opinions of the author, but not necessarily those of Sun Life or its subsidiaries and/or affiliates.