Lacy Hunt: Negative Real Rates Are a Strong Recession Warning

Please consider the Hoisington Management Quarterly Review and Outlook Fourth Quarter 2021. Emphasis Mine

Real Treasury Bond Yields

Real Treasury bond yields fell into deeply negative territory in 2021. In elementary economic models, this event, taken in isolation, would qualify as a plus for economic growth in 2022 and would be consistent with the strength indicated by fourth quarter 2021 tracking models.

Lacy a different view however. His analysis shows that negative real yields are associated with recessions. 

Debt overhang and demographics make the matter worse.

History

Since 1870, the starting point of reliable data, only 24 full yearly averages were negative, or just 16% of the 152 readings over this time span.

Detailed parsing of the series reveals that 12 of those occurrences fell in the spans from 1914 to 1920 and 1939 to 1953, both of which were dominated by major military engagements and their subsequent demobilization – World Wars I and II and the Korean War.

Excluding the 1914-20 and the 1939-53 periods from the post 1870 sample still leaves a robust sample of 130 readings. During this lengthy span, cyclical and secular economic conditions resulted in a negative yearly average for real Treasury bond yields twelve times, or just 8% of the time. In the eleven cases prior to 2021, nine of the negative real yield periods coincided with recessions – 1902-03, 1907, 1910, 1912, 1937, 1974-75, and 1980.

Real long maturity yields were negative in 1934, which while not a recession year, happened during the horrific conditions of the Great Depression (1929-1939). In only one case, 1979, does the negative real yield happen during an economic expansion when the economy is not in a highly depressed state.

Debt Overhangs and Real Interest Rates

The level of indebtedness of the economy is another of the critical moving parts in assessing future economic growth. Based on empirical evidence, theory and peer reviewed scholarly research, the massive secular increase in debt levels relative to economic activity has undermined economic growth, which has in turn, served to force real long-term Treasury yields lower. This pattern has been evident in both the United States and the more heavily indebted Japanese and European economies.

Real 10-Year Government Bond Yields 

Economic research provides additional insight and evidence as to why interest rates fall to low levels and then remain in an extended state of depression in times of extreme over-indebtedness of the government sector. While differing in purpose and scope, research has documented that extremely high levels of governmental indebtedness suppress real per capita GDP. In the distant past, debt financed government spending may have been preceded by stronger sustained economic performance, but that is no longer the case.

When governments accelerate debt over a certain level to improve faltering economic conditions, it actually slows economic activity. While governmental action may be required for political reasons, governments would be better off to admit that traditional tools would only serve to compound existing problems. For a restless constituency calling for quick answers to economic distress and where inaction would be likened to an uncaring and insensitive attitude, this is a virtually impossible task.

Carmen Reinhart, Vincent Reinhart and Kenneth Rogoff (which will be referred to as RR&R), in the Summer 2012 issue of the Journal of Economic Perspectives linked extreme sustained over indebtedness with the level of interest rates. In this publication of the American Economic Association, they identify 26 historical major public debt overhang episodes in 22 advanced economies, characterized by gross public debt/GDP ratios exceeding 90% for at least five years, a requirement that eliminates purely cyclical increases in debt as well as debt caused by wars. They found that the economic growth rate is reduced by slightly more than a third, compared when the debt metric is not met.

Persistent Global Weakness

Advanced Economies (AD)

In 2021, the Japanese, Euro Area and Chinese economies, in comparative terms, underperformed the U.S. economy. This pattern should continue this year. Due to more massive debt overhangs and poorer demographics, real GDP in Japan and the Euro Area in the third quarter of 2021 was still below the pre-pandemic level of 2019. The U.S. in this time period managed to eke out a small gain. The dispersion between the U.S., on the one hand, and China and Japan, on the other hand, may be even greater. Scholarly forensic evaluations have found substantial over-reporting of GDP growth in China and now, similar problems have been revealed in Japan.

Prime Minister Fumio Kishida said on December 15, 2021, that overstated construction orders had the effect of inflating the country’s economic growth figures for years. Consequently, the marginal revenue product of debt is even lower than reported therefore so is the velocity of money for both Japan and China. Interestingly, Bloomberg syndicated columnist and veteran Wall Street research director Richard Cookson makes a strong case that “China looks a lot like Japan did in the 1980s.”

Emerging Market Economies (EM)

The sharp surge in inflation in 2021 has resulted in far greater damage to the EM economies than the U.S. for three reasons. First, a much higher proportion of household budgets are allocated to necessities than in the United States since real per capita income levels are much lower than in the U.S. Second, numerous EM central banks increased interest rates in 2021.

Another problem emerges as most of the EM debt is denominated in dollars. When EM currencies slump as in 2021, the external costs of servicing and amortizing debt add an additional burden on their borrowers.

Growth Obstacles

In 2022, several headwinds will weigh on the U.S. economy. These include negative real interest rates combined with a massive debt overhang, poor domestic and global demographics, and a foreign sector that will drain growth from the domestic economy. The EM and AD economies will both serve to be a restraint on U.S. growth this year and perhaps significantly longer. The negative real interest rates signal that capital is being destroyed and with it the incentive to plough funds into physical investment.

Demographics continue to stagnate in the United States and throughout the world. U.S. population growth increased a mere 0.1% in the 12 months ended July 1, 2021. This was the slimmest rise since our nation was founded in the 18th century, along with two other firsts: (1) the natural increase in population was less than the net immigration, and (2) the increase in population was less than one million, the first time since 1937. The birth rate also dropped again.

Inflation

Inflation has been one of the most widely reported and discussed economic factors in the past year. Surging energy, rents, building materials, automotive, food and supply disruptions have boosted the year-over-year rise in the inflation rate to the fastest pace in decades. While some see this increase as a good economic sign, its increase actually had the effect of reducing real earnings by 2%. Even though unemployment fell in 2021, consumers became more alarmed by the drop in real wages according to surveys.

With money growth likely to slow even more sharply in response to tapering by the FOMC, the velocity of money in a major downward trend, coupled with increased global over-indebtedness, poor demographics and other headwinds at work, the faster observed inflation of last year should unwind noticeably in 2022.

Due to poor economic conditions in major overseas economies, 10- and 30-year government bond yields in Japan, Germany, France, and many other European countries are much lower than in the United States. Foreign investors will continue to be attracted to long-term U.S. Treasury bond yields. Investment in Treasury bonds should also have further appeal to domestic investors, as economic growth disappoints and inflation recedes in 2022.

Thanks to Lacy Hunt 

Thanks again to Lacy Hunt for another excellent Hoisington quarterly review. The above snips are just a small portion of the full article. 

As of this writing, the article is not yet posted for public viewing but should be available at the top link soon.

When Does the Sizzling Economy Hit a Recession Brick Wall?

I addressed many of the same points on January 17 in When Does the Sizzling Economy Hit a Recession Brick Wall?

I discuss productivity, demographics, and unproductive debt.

Something Happened

“Something has happened in the last 30 years, which is different from the past,” says Minneapolis Fed president Neel Kashkari.

Yes it has and the Fed is clueless as to what it is.

The answer is unproductive debt is a huge drag on the economy. And the Fed needs to keep interest rates low to support that debt. 

When Does Recession Hit?

If the Fed does get in three rate hikes in 2022, then 2023 or 2024. And it may not even take three hikes. 

Also, please see China’ Central Bank Cuts Interest Rates As Consumer Spending Dives

Few believe China GDP statistics.

China posts a GDP target and generally hits it despite questionable economic reports, electrical use, etc., and with a property sector implosion.

Slowing Global Economy

China did not decoupled from the global economy in 2007 and the US won’t in 2022.

For discussion, please see US GDP Forecasts Stumble Then Take a Dive After Retail Sales Data.

Finally, please see The Fed Expects 6 Rate Hikes By End of 2023 – I Don’t and You Shouldn’t Either

Thanks for Tuning In!

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