The United States economy is now in its 19th month facing the most aggressive cycle of monetary tightening by Fed in history. Not only that, since the Fed is also shrinking its balance sheet by around $80 billion each month as part of quantitative tightening. However, when inspecting traditional economic indicators such as the unemployment rate, consumer activity, economic growth, or stock prices, no conclusion can be drawn that would be consistent with the above. At first glance, there is little to suggest that the economy is in an advanced phase of monetary contraction. Under normal conditions (although it is difficult to define "normal"), the growth of key interest rates at this rate, combined with quantitative tightening, would probably already trigger an economic recession and corresponding changes in economic indicators. So what is behind the fact that the effect of rates is not reflected in the economy as it should be? There are 3 main reasons that are specific to today's cycle and that have essentially created a buffer for the real economy that rates have yet to fully penetrate:
1. Fiscal expansionary policy
The US government has been borrowing at an unprecedented rate in recent years, including the present. This money is used to replenish the US treasury and also for regular investment in the economy, which has stimulating effects. This year saw a large expansion of the US fiscal deficit despite a strong economy. It must be noted that fiscal expansion during a period of strong economic growth is an unusual act and contrary to economic theory. This deficit was financed at the short end of the yield curve, with almost zero issuance of longer-term bonds. In other words, the US government opportunistically took advantage of the current situation by financing this new short-term debt using the Fed's reverse repo facility. These reserves are on the Fed's balance sheet, which banks, funds and other institutions let earn interest at the Fed's key interest rate. By issuing short-term treasury bills with a slightly higher yield than what the Fed offers, the US Treasury was able to pump these reserves onto its own balance sheet. Thanks to this, yields on longer-term bonds have not yet increased, liquidity in circulation has not decreased, and productively used capital has not been affected by this. As a result, more money was available to buy long-term and risky financial assets, which fueled the stock rally and risky assets in general. The liquidity freed up by this process more than offset the effects of quantitative tightening.
2. Strong balance sheets and excess saving
Many US companies and consumers have smartly locked in their debt for a longer period of time at record low interest rates in 2020-2022. This environment of very cheap debt was the result of post-covid economic stimulus by central banks in developed countries. In addition, companies were exposed to a very favorable environment where their margins reached extreme heights and profits broke new records. This has contributed to the strong balance sheets of these companies, which are able to withstand tough economic conditions longer on average without having to make significant layoffs. In addition, the newly printed funds also ended up in the hands of consumers through faster wage growth, or even direct checks in the case of US citizens. Companies and consumers thus had the opportunity to create excess savings that are depleted over time, which supported and still supports economic activity to a lesser extent. Overall, economic growth has thus been preserved, although the rate of new loans has already collapsed significantly due to more expensive debt.
3. Imbalance in the supply sector
The post-pandemic situation resulted in a significant deformation of supply chains, with many of them disappearing in the first phase. In the second phase, with increasing consumer activity, the pressure on suppliers increased and it became more and more economically lucrative to do business in this sphere. As monetary tightening slows consumer activity to some extent, there has been a "shootout" in the recovery of the supply sector. Thanks to this, a surplus was created, which significantly contributed to the reduction of high inflation, while economic growth was not significantly affected. In response to falling inflation, markets have come to expect a quick end to monetary tightening and a transition to easing, which has supported asset prices.
Conclusion
As a result of these impacts, spending continued to rise, growth stabilized, unemployment remained low, and money flowed into asset markets. How these dynamics have affected the US stock market can be seen by breaking down the factors affecting stock performance. These are the effects of risk premiums, discount rates and cash flows. As spending was able to continue, cash flows were resilient to tightening, while the government's easing of liquidity supported a decline in risk premium and limited headwinds from rising discount rates over the past 12 months. This momentum has seen the stock market avoid a deeper decline (so far). If we had to guess, these 3 reasons will turn against the economy and risk assets over time. Markets are already feeling it due to the influx of longer-term government bonds that do not have adequate demand. Because of this, yields on benchmark US treasuries are rising rapidly, which is bad news for the economy and the markets. Without economic contraction, a balance will not be reached that will allow stable (magic number, LOL) 2% inflation. Recession is a natural cyclical matter, and trying to avoid it at all costs could backfire on the US in the longer term.
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