Economic growth and corporate earnings look solid, unemployment is the lowest in decades and there’s no inflation to speak of, so the U.S. economy and world markets can take two or three more U.S. rate hikes in their stride, right?
Household debt in the United States has never been higher, lifted by record levels of auto and student loans, and financial markets – Wall Street, world stocks, high yield “junk” bonds – are stretched, in some cases like never before.
It may not take much more tightening for them to snap.
The first cracks in this year’s world market rally started to appear earlier this month. A selloff in high-yield bonds spilled over into Wall Street and other bourses, volatility spiked and the U.S. yield curve compressed further to its flattest in over a decade.
Bank of America Merrill Lynch’s global junk bond index fell two weeks in a row, a downturn not seen for a year. According to the U.S. bank, investors pulled $6.8 billion out of high-yield funds in the week to Nov. 14, the third biggest redemption on record.
It’s worth remembering just how low “high-yield” bond yields actually are. They recently fell below 5 percent on a global basis and almost dipped below 2 percent on a European basis. That meant sub-investment grade corporate bonds in Europe yielded less than U.S. government debt.
You can see how vulnerable these markets are to higher interest rates, even though the Fed is doing all it can to ensure its current tightening cycle is the most telegraphed and gradual in history.
The problem is, the Fed doesn’t know where the neutral rate of interest is. That’s the level of interest rate where the economy is growing at trend, below which may encourage reckless investment and borrowing but above which may tip businesses, households and growth over the edge.
The Fed sees the neutral rate around 2.75-2.80 percent. That’s down from 3 percent in June and effectively 100 basis points below its projection in early 2015. There’s no guarantee it won’t go lower still.
The Fed has raised rates by 25 basis points four times since December 2015 and by its own reckoning will continue prodding the economy and markets with further gradual increases over the next couple of years.
Pascal Blanque, who oversees 1.4 trillion euros ($1.65 trillion) at Amundi, one of Europe’s largest asset managers, argues that the Fed faces an asymmetric risk of overestimating the neutral interest rate.
“They’re walking on thin ice,” says Blanque, warning of frailties in the U.S. economy that lie just below the apparently solid “cyclical surface.”
A study published by the New York Fed last week highlighted some of these potential weaknesses. Total U.S. household debt rose $116 billion to a peak of $12.96 trillion in the third quarter. That’s $280 billion above the previous record set – ominously, perhaps – in the third quarter of 2008.
Mortgage debt is lower today than it was in 2008, but auto loan and credit card debt is higher. Default rates in these two segments are rising, the report found.
Johnna Montgomerie, a senior lecturer in economics at Goldsmiths, University of London, says the Fed is attempting the same “plate spinning act” it tried in 2004-06 – hoping household debt can continue rising enough to fuel wider economic growth as interest rates gradually move higher.
But like last time, it’s an act that’s doomed to fail. Households have become as dependent on debt to sustain living standards as policymakers have become reliant on household debt to sustain economic growth.
“Neither is sustainable,” Montgomerie says, arguing that it will be almost impossible to reduce household debt without causing a recession. “The only way to keep the economy growing is through more debt, and the very thing stifling growth is debt repayment. It’s a debt trap.”
Certainly, the bond market is showing no faith in the Fed’s ability to pull this trick off. The yield curve is its flattest in a decade, suggesting the economy’s remarkable expansion of the last eight years is about to lose steam or worse. It is just basis points away from inverting, the classic (and uncannily accurate) sign that recession is looming.
The speed of flattening recently has been remarkable, having compressed 20 basis points since the start of November. At that rate, it will invert in January and the Fed might well find out how thin the ice it’s skating on really is.