The End (of the Business Cycle) Is Nigh – What Next?

Summary

• Understanding business cycles is a key input into any investment process.
• We are currently in the end phase of the current business cycle.
• The likelihood of a recession rises during this phase, although this outcome is not inevitable.

Introduction

The concept of the business cycle has always fascinated me. And I have always thought understanding it is important for improving investment and trading decisions. Given these unprecedented times, getting to grips with the current state of play, what it means for the Fed, and what will follow in the macro landscape is tricky but critical.

Scholars have devoted numerous volumes to the topic in the last several hundred years. Economists from Adam Smith to Friedrich Hayek to John Maynard Keynes, and many others, have explored the cyclical nature of business. And while a study of these thinkers would be worthwhile, this piece will focus more on the here and now. Based on a conversation Bilal Hafeez had with Boris Vladimirov of Goldman Sachs, it explores the current business cycle and its implications for policymakers, markets and the economy.

The Current Business Cycle

Bilal began the podcast by asking, ‘Where are we in the current business cycle?’ Boris responded by saying that we are currently in an end-of-cycle phase, with recession probabilities rising. This means we are transitioning from a high nominal growth phase to a phase where financial conditions tighten materially because of monetary policy. That leads to a crunch point in which markets and the economy both decelerate rapidly, inflation expectations are reset, and a new cycle begins.

One key point to make about the current cycle is the impact of Covid. Before the Second World War and the onset of fiat money (which Boris describes as ‘the greatest invention of the twentieth century’), business cycles were quite short. There were recessions every two or three years under these ‘very rigid money systems.’

Once the fiat money system took hold, business cycles became longer, including the pre-Covid period. Boris suggested we might see faster, more volatile cycles post-Covid. The question for now, at the end of the current cycle, is how this all plays out – will we experience a shallow recession, or something more sinister?

Fed/Macro Scenarios

Looking ahead, Boris outlined three different scenarios when the podcast was released in July.

Scenario One: Top Landing

The first, and most benign, outcome is what Boris described as a ‘top landing.’ In this scenario, spot inflation drops, and inflation expectations fall faster than expected. The Fed takes the Fed Funds policy rate to 3.25%, five-year inflation expectations settle at around 2%, with a real rate around 1.25%.

Ahead of the FOMC’s December policy announcement, the Fed Funds rate is already at 3.75-4%, with the futures market expecting Fed Funds to top out at around 5% next June/July. According to the St. Louis Fed, the five-year breakeven inflation rate is currently around 2.3%. This means that the real rate is above Boris’s criteria for the ‘top landing.’

Scenario Two: Sticky Inflation Expectations

A second scenario sees five-year inflation expectations remaining sticky (near the 3% level when the podcast was released), with the US short-end rates market pricing Fed policy rate expectations above 4%. Although the numbers are not perfectly aligned with Boris’s prognosis, this is reasonably close to the current macro conditions.

Scenario Three: Hard Landing

A third scenario, most closely aligned with a potentially deep recession, sees a very sharp weakening of demand with a concomitant increase in the savings rate as financial conditions tighten. Boris described this scenario as being characterised by a fast convergence to a disinflationary environment.

The Current Liquidity/Credit Regime

Intuitively, banks have turned more cautious since the onset of the pandemic. Use of the Fed’s Reverse Repo Facility (RRP) has increased, allowing financial institutions to get hold of Treasury Bills through the Fed’s balance sheet.

By using the RRP, the banks seek to hold the safest securities and access them directly from the central bank, meaning they are unwilling to put capital at risk elsewhere. It is an inherently defensive posture. According to Boris, this has meant that $1.4tn had been taken out of the system in the previous year.

This new liquidity regime has consequences for bank credit growth, although Boris says it is not clear yet what the implications will be. On the one hand, the defensive posture characterised by the increasing use of the RRP means that credit growth should be constrained.

Beyond these money supply metrics, however, is an equally important aspect – the overall feeling and level of risk aversion among borrowers. Boris notes that the level of employment and the balance-sheet quality of US households is healthy. Moreover, for US corporates, the interest payments to revenue ratios are also still relatively healthy.

Boris says these liquidity/credit metrics are good recession predictors, and that they are still showing a relatively low probability of recession. With a healthy private sector, this points to the second scenario outlined above being more likely than the third, deep recessionary scenario.

Conclusion

We are currently in the end phase of the current business cycle, with recession probabilities rising. Going forward, after the shock of Covid, these cycles will now probably become shorter and more volatile.

At this stage of the cycle, there are three scenarios for the Fed and the US economy. The most benign outcome, the ‘top landing,’ probably will not occur as Fed policy is (and will become even) more restrictive than is consistent with this scenario. Liquidity and credit metrics reduce the probability of a deep and lengthy recession, however, meaning that the economy will probably experience something between the best- and worst-case scenarios.

Richard Jones is a Macro Strategist for VDK Capital, a London-based venture capital firm. He has traded and invested in interest rate and FX market portfolios spanning three decades, both on the buy-side and sell-side.