Mission Accomplished: Soft Landing
Why celebrations of a "soft landing" are premature and a "hard landing" is still likely
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Okay, now onto our story!
Congratulations, everyone! The Fed has successfully delivered the “soft landing” that they were hoping for. Inflation is coming down, the stock market has been melting up, and it’s Mission Accomplished.
For conclusive evidence, look no further than the uptick in mentions of “soft landing” versus “hard landing” in the media. Surely, that is proof enough, right?
There’s just one problem: the lag effect.
When macroeconomic conditions cause the economy to grind into recession, it doesn’t happen overnight. It takes 12-18 months for these changes to flow through to key economic indicators. Consumer confidence doesn’t flip overnight. Similarly, job cuts only surface as reactions to shrinking revenue, after spending tightens for consumers and businesses alike.
In fact, history shows that market observers fall for this very trap while the lag effect is slowly playing out: it looks like a soft landing, until it’s not. This may be largely because human psychology commonly underestimates the extent of the lag effect following monetary policy tightening & misattributes the resilience of key metrics to economic strength.
Personally, I think a big reason why people underestimate the lag effect is that it’s not well defined. It’s hard to respect a hand-waivey hypothesis that it simply takes a lot of time for monetary tightening to precipitate the high unemployment we associate with recessions.
For this reason, I find the HOPE framework from Piper Sandler’s Michael Kantrowitz compelling in its effort to highlight and explain the lag effect in terms of the stepwise mechanics of a developing recession:
Housing – activity peaks in advance of rate hikes, begins to slow in anticipation of rate hikes
Orders – slowdown in consumer confidence & manufacturing comes next
Profits – consumer & business spending tightens, causing corporate profits to sag
Employment – slowdown in profits necessitates headcount reductions; unemployment spikes
In terms of this framework, I think it’s reasonable to say that we are currently somewhere between P and E. In that sense, we have not seen a spike in unemployment. However, it seems foolish to claim that the lack of high unemployment is evidence of a successful soft landing. Instead, it stands to reason that the job losses have just not yet materialized. It may be that this time is different, but that’s not a bet I’d be quick to take.
In fact, if unemployment were to spike, it would probably be preceded by employment data beginning to underperform expectations. As it happens, we have seen negative Nonfarm Payroll revisions for 6 months straight, which hasn’t happened since late 2007 and early 2002 (at the start of notable recessions).
These factors are gloomy enough in their own right. However, we also have to layer in the US fiscal situation to this picture…
Interest & Debt Issuance
The math is not very kind. The US has normalized multi-trillion-dollar annual spending deficits. These have added up to ~$32.7T in US National Debt. For a full breakdown on the US fiscal situation, check out this recent deep dive.
Now that the Fed has hiked interest rates to 5%, this means that the US National Debt’s effective interest rate is inching upwards as existing debt rolls over at the current rates.
In fact, $9T of the US National Debt will roll over in the next 18 months. This will increase annual interest expense by ~$300B on top of the ~$400B increase already added over the last 18 months.
Together, this $700B in incremental annual interest expense is roughly the size of the annual U.S. Department of Defense budget (~$800B). In other words, the Fed’s interest rate hikes effectively mean that the U.S. has to find the money to pay for an entire extra military, despite the fact that we don’t have any money because we haven’t balanced the budget in 22 years.
So where will it come from? We are issuing more debt. Last week, the U.S. Treasury updated its expected borrowing estimates for the rest of the year. The official numbers? To make it through the next 5 months, the U.S. Treasury anticipates needing to borrow $1.85T through new debt issuance. That’s in addition to the ~$1.3T of new debt issuance since the debt ceiling was lifted just two months ago.
Together, that’s more than $3T in new debt issuance to get through 8 months. In response to these latest estimates, major ratings agencies took the long-overdue move of downgrading the U.S.’s credit rating.
But what happens when this new debt is issued? While it ultimately expands the monetary base in the long-term (driving inflation), the short-term impact of debt issuance is that it soaks up dollars in the financial system. When the government issues debt, they are effectively asking the market to hand them dollars today in exchange for a contract to receive more dollars in the future. In other words, debt issuance is a liquidity sponge. And that is perhaps the most compelling reason why the “hard landing” is likely still coming.
It's probably no coincidence that the debt ceiling standstill that dominated the first half of 2023 coincided with an unexpected equities rally. While the U.S. Treasury was unable to issue new debt for ~6 months, all the liquidity that would have been soaked up by that new debt issuance was instead left to bid up existing equities.
But that is changing now. For this reason, Stan Druckenmiller sees the back half of 2023 as likely to be starkly different to the front half of the year, with the liquidity dynamics pointing towards a hard landing on the way. Here is his recent explanation…
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