Macro analyst Richard de Chazal reflects on the resilient year and expands on his 2024 Outlook’s key themes, including the sticky pockets of inflation, the 3 keys the Fed needs to achieve success next year, Treasury Secretary Yellen’s “Operation Twist” reboot, and more.

Podcast Transcript

Chris Thonis
Welcome to another episode of Monthly Macro. Richard and I are going to do something a little different in this episode by looking at what may be ahead for the economy in 2024. So, Richard, thanks for joining. Let's kick this off by walking through some of the top-line takeaways from your annual Economic Outlook report. You subtitled it “Testing Resiliency,” which is a nod to the continued strength of the economy and the question that continues to perplex many, “Is a recession still imminent or are we in for a soft landing?”

So why don't we start there? The consensus seems to have given up on the notion that a recession is imminent. But in your note, you said that the probability still looks uncomfortably high. Do you mind unpacking that a bit?

01:03 - 05:51
Richard De Chazal
Definitely, Chris. Well, certainly the market, maybe just because of the end of the year, the market is feeling sort of good at full animal spirits, very festive. I think its view seems to be not what it was last year.

So at this time last year, there was a full consensus that we would be moving or the economy would be moving into recession. That hasn't happened and as we've just about finished the year, everyone's now convinced that the soft landing is in and we're kind of there and we've seen a big rally in the market taking place on the back of that. That's kind of encouraging, but I am a little bit concerned that we're not quite there yet.

I mean, certainly, 2023 has been resilient. If that's one word, I think that personifies the whole year. A lot of things that could have happened didn't: Silicon Valley Bank didn't turn into a global financial crisis, the Russia-Ukraine war or Israel, Gaza, not yet, at least not quite over yet, but hasn't turned into a sort of major wider regional conflict or World War III, as some are already talking about. But it’s a bit still a bit too early to raise the sort of mission-accomplished flag just yet on the economic cycle. I still think that there are some lag effects that will come through from higher interest rates that still have to kind of work their way through the system to not be able to give that “all clear” sign yet.

But maybe on the plus side, though, I do think there are some legitimate reasons that we can believe that there won’t be at least a very hard landing, if you see what I mean. So, I think they're probably four reasons why this will be a more mild recession than maybe some of the ones we've seen in the past.

And I think the first is really that going into this, we don't seem to have the major excesses that we had in the past in terms of corporate balance sheets or consumer balance sheets. They're nothing like they were in ’08 or ’09. They're actually in pretty good shape. Consumers have been deleveraging for the last decade or so. And I think what you typically have to have to turn a sort of normal recession into a major financial crisis or a much deeper recession is sort of a deleveraging event and it doesn't seem like we're there just yet.

Secondly, I think perhaps what is different here, too, is that it's the Fed that's really driving this economic slowdown. So, again, it's not a pandemic. It's not a collapse in the banking system. It's very much a known unknown where the market individuals, corporate sector, they can kind of get their arms around what the Fed is doing. There isn't this sort of existential threat that you're looking down a tunnel of a pandemic, thinking we don't know where this is going or when it's going to end or a collapse in the global banking system. Similarly, we don't know where that's going to end. This is sort of a tried-and-true Fed tightening cycle. We know it has a beginning, obviously, and we roughly know when it has its end, and if something kind of breaks, we know the Fed can come in and try to turn things around by lowering rates very quickly.

So that's encouraging as well. I'd also say that because this sort of model of a textbook economic cycle playing out that I've been using, where we see the impact of higher rates rolling through the economy in kind of this domino manner, where it impacts the most interest rate sensitive sectors of the economy to the least interest rate sensitive sectors. That means that, again, not all sectors of the economy are getting hit at once. They're not all declining at once. So, the depth of that recession is going to be milder where you could have some sectors coming out of the slowdown, just as others are kind of moving lower.

And I guess finally, which is encouraging as well, and something we certainly see at William Blair a lot of are structural growth drivers here. And I think what we see is that even if you have this sort of cyclical slowdown going on, there's at least a structural support floor in many areas of the economy, whether that's housing, manufacturing, healthcare, and perhaps most obviously, this new innovation wave of generative AI, all that kind of stuff. So, I think that helps again, to limit the scope and depth of any economic downturn.

05:52 - 06:12
Chris T
So you went into a little bit about what a mild downturn might look like. Would you mind just breaking down the differences between a mild downturn that we're hearing a lot about, a soft landing? There's those two different types of ending points would be the best way I can put it. Well, how would you describe both, I guess would be my question.

06:13 - 08:05
Richard D
I mean there’s no formal definition of either. I do get that question from clients that “Well you're sort of painting this kind of mild recession. What really is the difference between that and a soft landing?” I think there are two important differences. The first is that recessions tend to be broad-based slowdowns, where you get declines in employment, industrial production, you get declines across a really broad swathe of the economy and soft landing, say, like 1994, ’95, you didn't get that. 2015 and ’16. You could even consider as not necessarily a Fed induced soft landing, but it was a slow economy, but it was very confined to the energy sector of the economy. I think basically two important things are worth noting. The first is that in a recession, even a mild recession, the unemployment rate rises on average. If you go back, and look at past recessions, on average, the unemployment rate around recessions tends to rise by about 3.6 percentage points. A mild recession would presumably be below that. So, something similar could describe a mild recession, maybe the 2001 recession, where the unemployment rate still rose to 2.6 percentage points. Again, I think this time around, for structural reasons, in a structurally tight labor market we might not get that high either. But I think that's one thing. And the other thing is in terms of Fed rate cuts. So, in a soft landing, the Fed doesn't cut as much, and in a recession, even a mild recession, the Fed will take down rates much further.

08:05 - 08:18
Chris T
How painful is a mild recession or mild downturn normally? I know that a soft landing is what everybody wants, but would you say a mild downturn? Is that something that we're feeling now or is that something that soon to come? What are your thoughts there?

08:18 - 09:09
Richard D
Yeah, I mean, we're in the sort of slow economic slowdown now. We're not in recession yet. You can look at across a number of different economic indicators. If you look at the main ones, like the recession dating committee at the National Bureau of Economic Research, you can look at all of those and maybe one or two of them out of a basket have peaked and starting to come down.

So remember, recessions start at the peak of the economic cycle and then they end at the trough. So actually, they start when things are still feeling pretty good and no one kind of realizes we're actually in recession, which is why everybody talks of a soft landing always before the recession actually takes. And then the trough is when things by definition are at their worst, when everybody realizes the economy's in recession and it's actually starting to come out of that.

09:13 - 09:37
Chris T
So yeah, that's interesting. You talk about how phase one of the inflation slowdown is now largely over and we are headed towards phase two. You cleverly describe this as the baton of disinflation being passed to the demand side of the economy. So, can you walk through this a little bit along with why you still expect CPI to fall to 2% by the end of 2024?

09:37 - 10:01
Richard D
I think what's been interesting is how can we look at inflation sort of more holistically, you know, not just all the individual price indices. How can we kind of break it up into something that's really easier to think about how the dynamics work in the economy? There are a number of ways of doing that. The Atlanta Fed and the San Francisco Fed both break up inflation into two or three inflation buckets.

The Atlanta Fed looks at sticky prices versus flexible prices. The San Francisco Fed looks at supply-driven inflation versus demand-driven inflation. But they're both kind of the same thing. What we can see in these, particularly in the sticky or noncyclical prices versus the flexible non-sticky cyclical price indices, is that all of the heavy lifting that we've seen so far in the inflation basket has been driven by these flexible cyclical prices, largely the goods component of the CPI, whereas the sticky components have come down, but not all that much right.

If we're sort of I think we're in this, that was the first phase where the cyclical stuff comes down quite quickly. And that happened as supply chains cleared, the ports opened again. All the companies that were missing inventory got it again. So those prices came down, whereas the sort of demand-side inflation is more driven by wages and labor force dynamics, that kind of thing.

And what I think we're seeing is we're now at this point where much of the positive disinflationary force from the flexible, non-sticky stuff has kind of run its course and you need this sort of passing of the baton to the stickier stuff to go into the next phase to bring inflation lower. And I think that's happening. But the concern and certainly a concern at the Fed is that you could kind of get this fumbling of the baton as that one driver is passed to another.

For example, we could see that the disinflationary force from goods prices now is dissipating and maybe those prices start to increase if companies start to restock again. So a big driver has been inventory liquidation over the last nine months or a year. And if that's done, and then the corporate sector says, hey, you know, soft landing, we should start rebuilding our inventories again, that could start to push up prices a little bit and maybe that could happen before we get enough downward trajectory in the stickier prices, before we start to see more weakness in the labor market. And we had a recent employment report that was pretty decent that put the skids a bit under this view that the Fed is going to start cutting rates very, very quickly. So I guess my point is that I think we're heading in the direction of two, two and a half percent inflation by the end of next year.

The major component of those sticky prices is really the shelter component and the way the Bureau of Labor Statistics calculates it tends to lag real-world rent prices by about 10 to 12 months. So we know what those rental prices are doing and we know there's a strong follow-through there and what's going to happen to the CPI shelter component.

So that's going to happen. It's just the next few months or so where things could be a little bit wobbly before you kind of get this handover. And I think the Fed is concerned that within this period, if inflation doesn't continue to come down, maybe you get a spike in oil prices because we get a cold winter and Putin turns off the taps or whatever that the fear would be that causes a spike in inflationary expectations.

And it's worth noting that we already saw a big spike in the University of Michigan survey’s inflationary expectations in components for the coming year in the next 5 to 10 years. So that won't go unnoticed by the Fed. So I think we get there in the end, but it's just this kind of near-term term, a little bit more of uncertainty about where we're going on that, and hopefully no fumbling of the baton as that process plays out.

14:09 - 14:20
Chris T
In the report, you always talk about the Treasury's version of Operation Twist. This is in reference to the bond market. What's that all about? Do you mind walking us through that?

14:20 - 14:39
Richard D
Sure. I think it's quite interesting, actually, and I think it's going to be quite an important theme for 2024. So you probably remember the Operation Twist was something the Fed originally did back in 1961, or I don't remember that, but I’ve read about it.

But I do remember the 2011 when they did Operation Twist, and probably most of us will remember that as well and that was when the Fed started to sell short-term debt off its balance sheet or, let me correct that, not sell but didn't want maturing debt at the short end of the debt it was holding. When that was rolling off its balance sheet instead of rolling it or investing it back into shorter-term debt, they reinvested that back into longer-term coupon treasury bills. And the goal of that was to try and twist the yield curve to lower those longer-term bond yields without actually increasing the size of its balance sheet. So, kind of a QE without actually a hit to the balance sheet. It was pretty clever. And I think Treasury Secretary Yellen, who let's not forget, used to be Fed Chair Yellen, Fed Vice Chair Yellen, president of the San Francisco Fed Yellen, and Board of Governors Yellen.

She's very familiar with Operation Twist. And one way of thinking about what she's pulled recently at the Treasury is her own version of Operation Twist. And we probably need to back up here a minute because I think if you remember what we got through middle of this year and up until a few weeks ago was a big sell-off in bond yields or big rise in bond yields/sell-off in the bond market, which is to a certain extent been unwound now.

But a big concern for the Treasury and Yellen, who has to issue a lot more debt and issue it as cheaply as possible, particularly at a time when Washington wants to run 6% budget deficits in the middle of an economic expansion. They normally issue this debt or the ratio of outstanding debt for the Treasury normally has a ratio of bonds and notes to bills of about 80% to 20%.

So what I think we've been seeing recently is she's been switching those or twisting those where she's now been forecasting through the QRA, which is the quarterly refunding announcement, which the Treasury announces. She's announced that the Treasury is going to issue a lot more Treasury bills than bonds in something like 60/40, which is a twist if you will.

And that's a huge surprise for the bond market. The bond market wasn't expecting that because, in their previous array, they weren't forecasting that. And in this latest one, they not only revised those forecasts but pushed them up quite significantly. I mean, normally the Treasury talks a lot to the primary dealers. They usually have a good idea and everyone has a kind of cozy idea about what the Treasury is going to do, how much the market can absorb.

So this was a pretty big surprise in what is normally a fairly sort of staid and boring process. Right. And it's officially supposed to be that, you know, you don't want a lot of uncertainty when it comes to issuing treasuries in the bond market. So I think it was a pretty smart move by Yellen to do this kind of twist, issuing more bills than bonds because coupon debt at the time was quite expensive.

And secondly, the demand for T-bills is at the moment and still quite high, particularly when the Fed or the market is running down this reverse repo program, which is money that's being parked at the Federal Reserve in their reverse repo program, it's now coming out of that and back into T-bills and money market funds at a time when those interest rates are now quite attractive.

So that's been something that's helped to provide a lot of liquidity to the market in the near term. So I guess what Yellen thought was let's do our own Operation Twist by issuing more bills than bonds. So instead of attacking the yield curve on the demand side, like she did at the Fed, we're doing it on the supply side.

So far, that's been pretty successful. She's managed to kill the momentum in rising bond yields, and I think there was also a clear message that the Treasury is hearing the bond markets pain, they're sensitive to it. The market has rallied quite hard into that. The problem, however, is that this issuance structure won't last. And going into next year, at some point she's going to have to twist back or else you risk the duration of that debt starting to fall more than the Treasury would be comfortable with.

And I think the problem here is also that the liquidity support for the market through this reverse repo program is going to end probably in Q1. So, some of that liquidity will dry up. But I think Yellen is thinking by the time that happens, inflation will be firmly back down or heading on its way to 2%. Growth will be moderating, potentially even in recession.

And the Fed will have already started its easing cycle. So investors, when it comes time to switch, will actually be demanding more longer duration debt and less T-bill debt. So, let's see, it's pretty smart on her behalf. Hopefully her gamble pays off on this one.

20:48 - 20:57
Chris T
All right. So we talked about the Treasury. I feel like this is a good segue way into the Fed. What are your overall expectations for them in 2024 and maybe even beyond?

20:57 - 26:37
Richard D
I think if the Fed manages to engineer this soft landing, as everyone's now expecting, you know, kudos to them. I think Powell can get his spot secured in the Fed Hall of Fame, if you will. Yeah, I mean, I think we're clearly on the cusp of the easing phase. I think the peak in the rate cycle is in.

The Fed is already held off easing for longer than they previously have done. So normally when rates peak, there's about five months or so before they start lowering interest rates. And by the time they do, this time around, it will be much longer. So that's something different. I think what's changed is in the last few weeks, I mean, only a few weeks ago I thought the market was being a little bit conservative with its expectations of just 50 basis points of cuts in 2024 and then we quickly move towards 75 and I thought, well, 75 to 100, that feels about right, that that's pretty sensible. But in just the last few weeks, we've blown through that 75 to 100 and gone to about 150. Maybe that's come back a bit with the latest employment numbers, but that's been some pretty rapid or deep change in a short period of time, and I think that's a little bit over the top.

I'm still in this 75-to-100 basis points camp in 2024. And where I do think the market is being conservative, though, is in its expectations for rate cuts over the entirety of the easing cycle. So over the next couple of years, the market is really only expecting about 200 basis points of cuts over this period. And I think that's somewhat conservative. I think you'll probably get more than that, and I'll give you a few reasons why.

First, I think we're moving from the Volker phase of getting rid of inflation to where he jacked up rates very high and kind of keep them high, higher for longer to the Greenspan phase of this sort of opportunistic inflation where you can kind of bring down rates, but do it slowly, drag your heels a bit, don't match market expectations or the declines in inflation one for one.

So from that perspective, I think Powell will continue to be a little bit slower on that. And remember, I was talking about the Fed worried about their credibility. That's still a big issue in their mind. And the second thing is how we should think about inflation even. Now remember, if inflation falls from, say, 4% core rate to two, two and a half percent by the end of next year, and you don't match that decline with a decline in your nominal Fed funds rate, you're actually still passively tightening policy.

And I think if we do get inflation coming down by 150 to 200 basis points and the Fed cutting rates by 100 basis points, that's still kind of restrictive. It's still kind of consistent with this sort of opportunistic disinflation where you want to grind down both inflation and inflation expectations and make that sentiment really stick. So I think from that perspective, 100 basis points feels about right.

And the third thing I guess I would add is a good way to think about how much the Fed might cut or what kind of ballpark we should be in is this sort of nebulous measure of r-star. Now, remember, r-star is an unobserved variable. It's the real neutral short-term interest rate for the economy. Anything any interest rate kind of above our star would be determined as the Fed or monetary policy as being restrictive and anything below it would be policy in accommodative territory. And the estimate currently of that R star rate is 0.5 to 1% in real terms. So if you throw on a 2% inflation on top of that, you're talking about nominal neutral rate of 2.5 to 3%.

So getting down to that would be your soft landing narrative. But even that demands a bit more than what the market is expecting. So the 250 basis points from or even 300 from the five and a half where we're at today, if you actually have a mild recession or a hard landing, you're even going to have to go beyond that, below that r-star rate.

So I think market expectations here are a little bit conservative. And historically, if you look back at the market’s behavior, it's generally tended to underestimate the amount of rate hikes that the Fed actually does in a tightening cycle and similarly underestimate the amount of easing that the Fed actually does in an easing cycle. So I think that's what's playing out next year. This sort of near term, maybe they've priced in a bit too much, but maybe not enough over the entirety of the easing cycle.

26:37 - 26:45
Chris T
Well, thanks, Richard, as always. Happy holidays, obviously, to you as well as the listeners. I look forward to chatting with you again in the New Year.

26:45 - 26:47
Richard D
Thank you very much. Happy holidays to you and to everyone who's listening.