The Inverted Yield Curve and Recession?

https://www.bloomberg.com/news/articles/2022-04-02/inverting-yield-curve-signals-high-stakes-for-fed-and-investors

https://www.reuters.com/world/us/ny-feds-williams-balance-sheet-run-off-could-start-soon-may-2022-04-02/

                I was checking the financial news feeds yesterday morning and found the attached 2 articles. The Bloomberg article continues the discussion on the inverted /inverting yield curve which is a pretty good advance warning sign for recession. The second, Reuters article, involves one of the Fed’s presidents, John Williams, and his views on Fed actions and reactions. Both are good for different reasons.

                The Bloomberg article is highlighting that many in the financial community are feeling the Fed needs to get the Fed Funds Rate up now to help bring inflation down. Talk of .50% and even .75% increases are now routinely discussed where a .75% increase wasn’t considered at all until recently. The purpose of the increases is to brake and break inflation. To brake the rate of increase and to break the rate down from the current 7.5% annual rate that is increasing, to the Fed’s long term target annual rate of around 2.0%. The article is showing that more and more groups are calling for higher and faster rate increases. The final paragraph in the Bloomberg article does a pretty good job of summarizing the possible outcomes of this -  “It’s not a done deal that we are going to have stagflation or a recession but we are getting close,” said Jake Remley, a senior portfolio manager at Income Research + Management, which oversees about $92 billion. “That inflection point is out there somewhere, and it’s possible that at some point we may hit it soon if they keep pushing the expectations for [Fed Funds Rate] hikes.”

                The second article from Reuters is a summary of comments by John Williams, one of the Federal Reserve Bank’s presidents. Williams is responding to questions about Fed intentions. It is not uncommon for various Fed bank presidents and some others to make limited statements about current Fed thinking or activities. They very seldom make a definitive statement and usually don’t say much more than generalities however, and this is very much on purpose. They sometimes use these types of settings to get a feel for what the thinking is in the markets. It is an interesting dance, the Fed tries to make calming statements with little or no content and then tries to “read” the comments from the market to see what the market may be thinking or may do. The market meanwhile tries to “read” what the Fed is saying (as the Fed tries not to say much) and get more information out of the limited statements. The reason for this dance is that the market can react very quickly to any information or direction it “thinks” is important. The Fed doesn’t want to diminish its ability to influence markets by telegraphing their plays. We had this problem in the 1970s-80s with Alan Greenspan and the raging inflation and interest rates of that period. Greenspan would share what he was thinking (kind of like thinking out loud, not necessarily  concrete, more exploring several ideas, we all do it)  with some of his people or other governmental people, congress etc. and within hours (sometimes if felt like minutes) the markets would have gotten hold of the information and reacted in some way or other. Greenspan finally had to stop saying anything just so he could think through things. That basically has carried over through all Fed officials since then, they don’t dare say anything before they want to act themselves. Remember, everything in the market is about information and perception or worse perceived information. Williams, as reported in this article, spent a little time relating past performance of Fed policies (in the 2019 Fed actions)  that were viewed by the Fed as being successful. Now if I was going to say that last statement as proper Fed-speak I would say something like; Many individuals in the market and government perceived our actions (Fed actions of 2019) as being somewhat successful and we believe given current conditions which may or may not be similar to conditions in 2019 that the Fed may be successful or not in doing something similar though not necessarily the same again, i.e. slow the economy without crashing it (recession). Do you get the idea. The article reports that Williams gave some general rate targets and hinted that the Fed might consider (the next section is my words not Williams but you get the idea)…., trying but may not try, still it might work, but there are no guarantees, but maybe….. something “like” the previous actions might, or possibly might not do something similar or not, in the current situation that may or may not be like the previous situation, maybe. Do you get the drift of the depth and breadth that the Fed people will go to to say something but not say something. The article goes on to say Williams suggests the high inflation rate is currently the “greatest challenge” for the Fed at the moment (which may or may not change) - nothing is ever a problem, just a challenge, and lists several factors likely influencing the current inflation trends. Notice in the list nothing is said about the Fed’s massive balance sheet which in my mind is the 900 lbs. gorilla in the room. Williams does acknowledge that the Fed is going to try to “ease inflation to around 4% this year and ‘close to our 2% longer-run goal in 2024’ while keeping the economy on track.” With inflation currently running at 7.5% and climbing that is a good goal. The trick to the whole thing is in Williams’ quoted remarks in the last paragraph, “These actions should enable us to manage the proverbial soft landing in a way that maintains a sustained strong economy and labor market”. That is really the goal, hope, prayer and fervent wish – a soft landing of the economy. The success rate of soft landings is, unfortunately, not particularly good.

                Stay tuned to the exciting continuation of the US Fed and the fight with the dragon of inflation. The year 2022 promises to be interesting (not problematic, of course). Think of the 1965 movie Those Magnificent Men in their Flying Machines. The first 3 lines of the theme song describe our likely market ride as the Fed attempts to bring the economy in for a “soft” landing. Think of the Fed as the pilot and the economy as the flying machine.

    Those magnificent men in their flying machines,

    they go up tiddly up up,

    they go down tiddly down down

from Those Magnificent Men in the Flying Machines theme song

… and up and down and up and down and up.

As the stewardess says, everyone please fasten your seatbelts we are entering turbulent weather.

What is your risk level (part 1) update

             Let’s try a thought experiment. Suppose you have an opportunity to make $1,000 by investing in a pool. However it costs $250 to participate in the opportunity. Let’s further suppose that the likelihood of making $1,000 is one-in-four times that you participate. Each time you participate you will lose your  initial participation fee of $250. Would you participate in this investment opportunity? If you knew that once in every four times you participate you will make $1,000 would you try. What if you thought that you might be successful on one of the first three times you participate? You may be from $250 to $750  ahead. You could then stop investing and take your increase. From a statistical perspective you would be indifferent on your chances of recouping your costs. You know that regardless of what happens, you can recoup your funds if you participate four times, assuming that the investment opportunity is really as you are told.  However how would you react if you had an investment opportunity that would return $5,000 one in every four times you participate but the participation fee is now $3,000. How do you feel about participating now? If you are not successful  the first time you invest you will lose $3,000 but if you invest again and the investment is successful you will have only lost $1,000 ($3,000 cost x 2 less $5,000 payout). But if you are unsuccessful you will have lost $6,000. Do you take your $3,000 loss or try to reduce your lose by investing in the pool the second time. Of course if your investment is successful on the first investment you have $2,000 in net funds over your initial cost.
              Now assume that instead of $1,000 as the potential investment earnings it is $1,000,000 and the cost of investing is $250,000. How do you feel about your investment earnings? Do you feel a bit more reluctance? Realize that the actual statistical odds have not changed but you may not feel as comfortable about this investment because you can’t afford to have to pay the cost more than once. Risk can relate to financial, economic, emotional, physical or mental situations. At what point are you uncomfortable with the level of risk in a particular situation? Or in other words, what is your risk level, are you risk adverse or risk tolerant?

             In the financial world advisors will suggest that you invest your money in a mixture of stocks and bonds. This is to spread your financial risk. You don’t suffer a devastating loss as the stock market falls but you don’t get the full benefit as it climbs. You hope that you get some positive benefit but it will be less than the possible maximum. There are ways to potentially blunt the impact of market gyrations. As in all situations, solutions can be complex or simple, wildly profitable or financially devastating or even breakeven (and you have potentially been on an emotional rollercoaster for no real benefit).
             In world building, the development of backstories, or story lines there is an opportunity to add depth to characters, groups, societies or races by developing and incorporating risk tolerance (or lack of tolerance) or risk reaction components. Characters or groups don’t usually weigh the odds of an action with a mathematical formula but they could subconsciously be influenced about how they perceive risk. The level of risk a character may be willing to assume will affect their reaction to situations. Is a character a rogue with a devil may care attitude (risk taker) or are they cautious and unwilling to expose themselves to danger (risk adverse). Will a risk adverse character get trapped by their failure to act or saved by their caution. As you consider character development consider the risk reactions for that character. How will they react based on their risk aversion or risk tolerance? How might they stay consistent, what would cause them to change their willingness to assume or shun risk. How or why might their risk reaction change. You can ask similar questions of groups, societies and races.