Macro Volatility Is Coming
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The S&P 500 realized volatility is below 10%, credit spreads are super tight and aside from some short-lived European political drama, markets keep marching higher. Yet, I think macro volatility is about to come back. First of all, we are suppressing economic cycles, injecting an artificial equilibrium which will only make the system more fragile in the long run. Basically, we are not allowed to have a recession anymore.

The first chart in the article from Professor Lee Kopok shows the number of months the US economy spent in recession in 30-year periods starting from 1870s until today. And the message is pretty clear: our economic system has become much more stable as we spend less and less time in recessionary conditions. But why? I would say there are three main reasons.

The first is geopolitical stability. Not rocket science here, but by having less systemically important wars you are going to have way more financial and economic stability. Number two: the shift from a gold standard to a fully elastic fiat money system. The gold standard works by pegging the fiat currency to a fixed hard asset whose supply can't be expanded. That's gold.

Doing that reduces the odds of rapidly expanding or devaluing fiat money over time. But the flip side to the gold standard is exactly that: by not allowing for a rapid expansion of fiat money creation when it's needed to stabilize the economy during a recession, for example, you will end up with more volatile economic cycles and therefore spend more time in recessions.

The gold standard has benefits but also downsides and after the 1970s we migrated towards a fully elastic fiat money system. But that meant that policymakers have been trying hard to cancel the concept of recessions. Because being able to expand fiat money creation in a fully elastic way is great, but politicians can abuse this system.

This leads to where we are today: policymakers are trying hard to erase the concept of a recession altogether, but in a capitalistic system that doesn't work. The side effect of suppressing natural economic cycles is that productivity levels will decline rapidly and most importantly, as Minsky once said, artificial stability is destabilizing for a system in the long run.

Recessions should be part of a standard economic cycle where the system is allowed to cleanse and restart stronger than ever. Yet, also this time, policymakers have chosen to artificially stabilize the economy. Take a look at the second chart in the article. That chart explains why the Fed hiked rates above 5% and yet the US economy does not break.

The last time Fed funds were raised aggressively towards 5% and kept there with a long hawkish pause was in 2006-2007.

And clearly something broke them, the US housing market, which broke havoc in the banking industry too and generated the biggest financial crisis in the post-WWII era. But there is a key difference between now and then. As you can see in the chart, the big money expansion in 2005-2007 was credit-driven. Today it's fiscal-driven.

Economies grow above potential if new money is getting created in large size. This can be done by the government with generous pro-cyclical fiscal stimulus like today or via the private sector credit, for example bank lending. And if brought to the extreme, these two sources of money creation lead to different imbalances over time. In 2005-2007, money creation was all about private sector borrowing.

The US private sector leveraged up a lot to chase the housing bubble via the subprime mortgage and credit market engines. Back then, the government was not a large contributor to money creation. It was all about private sector leverage and in 2007 the housing market started cracking under the pressure of that excessive private sector leverage.

Because you see, when private sector credit as a percentage of GDP rises uncontrollably, you often get a credit event or basically something breaks. You can think of the Japanese or the Spanish real estate bubble, the Asian tiger's fever or the US housing bubble or even China today. But as we look at the US economy today, the story is different.

Private sector credit is not the source of excessive money creation and instability today because the US private sector has actually deleveraged since 2008. Instead, it's all about government deficits today.

So the story is different. The scale of government deficits, which you see in orange in the chart in 2020-2021, was enormous. And that was by far the main driver of money creation, which is still today circulating in the economy. We also got another fiscal shock in 2023. While if you look at private sector credit, well, that's been moderating now for two years.

This means that the risk this time is not that something will break from excessive private sector leverage, especially in the US. The risk is that the US government keeps throwing fuel on the fire and it might end up re-accelerating inflation down the road and make the macro cycles more volatile. Which brings me really to the real source of upcoming macro volatility: US elections. Since the presidential debate, the bond market has been sending an interesting signal.

As the debate ended, Biden's underperformance led to a sharp increase in the odds that Trump might be the next president. The bond market didn't take long to respond. The yield curve has been steepening pretty strongly since then. Take a look at the third chart in the article. It shows the market implied path ahead for Fed funds today in blue, two weeks ago in orange. And the panel below shows the difference in yields for each point in the curve. The steepening of the curve is very evident from that chart. But why is it happening?

So far, Trump's economic agenda involves three main things: a tough stance on immigration that's inflationary, because one of the reasons why the disinflationary path has been so friendly so far in the US, while the labor market holds, is because there has been a large addition in labor supply, mostly due to net immigration in the US. So hampering that labor supply would reduce growth while at the same time increase inflationary and wage pressures.

The second point is heavy tariffs on China, which is also inflationary because import prices could rise aggressively and volume of imports/exports around the world might even suffer as a result of increased protectionism. And third, Trump wants a weaker dollar and wants to pressure the Fed to cut rates.

So despite the US economy holding still fine and its inflationary policies were just debated, Trump wants the Fed to cut trades once a week a dollar. The risk is that the economy would then overheat, potentially generating further inflationary pressures. As Trump's odds of winning the race increase, so do the risks of inflationary policies while the Fed is pressured to cut trades, and this leads the bond markets to inject term premium.

As the uncertainty around future bouts of inflation increases, the curve has to steepen to guarantee a wider buffer or a higher-term premium for bond investors to get involved. And if volatility comes back in bond markets, well, you better watch out. I think right now we are watching the proverbial calm before the storm.

Now, this was it for today. Feel free to share the article around with friends and colleagues and enjoy your weekend. Finally, today, remember to tell someone that you appreciate them. This is it from Alf. Talk soon again here on the Macro Compass.