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It's a 3% World With 3% Growth and a 3% Yield Curve Because Three Is a Magic Number

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Stimulus or not, it is likely that this 3% growth rate represents the new structural growth potential of the US economy.

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Thursday's "better-than-expected" Q2 GDP report was supposedly cheered by equity investors who suddenly forgot about the emerging disaster in Syria that was meant to be the catalyst for weakness on Wednesday. The number that matters, year-over-year (YoY) nominal GDP, registered a 3.1% gain, up from the previous 2.9% estimate and equal to the 3.1% Q1 growth rate, which was the slowest quarterly growth rate since emerging from the recession in 2010.

The more important data point from the week was Friday's income and spending report, which provides the YoY growth rate of personal consumption, the biggest component of GDP and the first look at the Q3 run rate. The July YoY growth rate of personal consumption (PCE) registered a 3.1% pace after averaging 3.0% in Q2, 3.3% in Q1, and 3.7% in Q4. This key component of US economic growth remains near the lowest levels in the post-WW II era and also suggests the economy remains mired in 3% nominal growth.

With the Federal Reserve's monetary stimulus operating at full throttle since January, it's hard to believe that the economy can only garner a 3% nominal growth rate. As the Fed prepares to dial it back at its September meeting -- known as the so-called "tapering" of QE -- it will be interesting to see if we can even continue this modest pace. Stimulus or not, it is likely that this 3% growth rate represents the new structural growth potential of the US economy.

Based on the latest FOMC forecast, the Fed is projecting anywhere from 50 bps rise to a 3% Fed funds (FF) rate by year-end 2015, with a large consensus projecting a 4% rate in the long term. The Fed probably gets this number based on what it perceives to be the potential growth rate of nominal gross domestic product (NGDP), which averaged 5.5% through the 1990s and 5.1% from 2000 up until the financial crisis. However, on the back of the most stimulative Fed in modern history, growth is settling in at only a 3% rate. Can a 3% growth rate handle a 4% overnight lending rate?

Over the past 40 years, the FF rate has not spent a lot of time above the growth rate of NGDP without coinciding with (or causing) a recession, with the lone exception being the tightening cycle in 1994. In fact, the last time the FF rate was at 4% was in 2005, which arguably began the process of popping the credit bubble. At the time, 4% was still far below the 6.5% growth rate in NGDP. In fact, if you look at the average spread of NGDP growth to the FF rate going back 40 years, it is 70 bps, which at the current 3.1% NGDP growth rate, projects only a 2.4% FF. Odds are, if the Fed hike takes the interest rate to 4.0% in the context of 3.0% growth, money would get very tight, the curve would invert, and a recession would follow.

Nominal GDP Vs. Fed Funds Rate


Similar to the relationship between FF and NGDP, the 10-year yield tends to find equilibrium around the growth rate of personal consumption. Why is this? When the risk-free rate exceeds spending growth such as it did in 1990, 2001, and 2009, due to a collapse in aggregate demand (which resulted in a recession), the 10-year subsequently fell to ease credit conditions. Long-term interest rates will calibrate against the growth rate in nominal spending, lowering the cost of money when spending weakens to stimulate growth, and raising the cost when spending accelerates to tighten.

10-Year Vs. PCE


One of the perils of QE, which is exacerbated by the fact that it has lasted so long, is that the market has not been allowed to calibrate around the growth rate of consumption. The volatility we have thus far been witnessing is The Yield Curve Adjustment Process I wrote about on May 13.
Whether you believe the Fed has successfully manipulated the yield curve or not, just the fact that it is in the market means that no one really knows where Treasuries should trade. For this reason, we don't know where asset prices should trade. However, it seems that we are about to find out, and I think it is going to be a very uncomfortable process.

This is exactly what is happening. You have a lot of very levered bond market participants who own a lot of low coupons suddenly trying to figure out what is fair value.

The dealer strategists who blew up their clients' investments by convincing them that the Fed was controlling the long end of the curve are still trying to calibrate their interest rate forecasts based on whether the Fed is going to be buying. This focus on tapering shows a complete ignorance of what drives interest rates and where we are in the cycle. As I have been saying ad nauseam, the amount of bonds the Fed buys is irrelevant. It's not the flow or the stock; it's the discount.
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