The Days Ahead:

  • Short week; jobs report on Friday.

This Week:

  • We look at R* or natural interest rate which the Fed has started up again (it’s more interesting than it sounds)
  • There’s some good news about growth
  • It takes 24 months for inflation to fall from peak to trough, so why is the Fed rushing things?
  • The Legend of Zelda: Tears of the Kingdom…Japan has its spark back
  • A Q&A on the debt ceiling: when, how and what to expect
  • The bill market is very odd indeed

Program Note:

Star Search

There is this thing in economics that central banks call the natural rate of interest or R-Star or, even simpler, R*. It’s like the Holy Grail of interest rates as it measures, wait for it, the real interest rate, net of inflation, at which the economy is at full employment while keeping inflation steady and under control.

Well, you may be like me when I first heard about it and think “That’s nice but we’ve already got one…it’s very nice” and point to the 10-Year Treasury or the yield curve. But the search for R* started in the 19th century and continued on and off ever since.

It’s a great concept. If central banks could just find that rate at which everything works, the dual mandate of “maximum employment and stable prices” works and the economy looks after itself. The level doesn’t matter. If R* is 10% and inflation and employment steady, then fine, that’s what rates should be. The trick is to find it.

In the 1990s, a Professor Taylor, an economist at Stanford, came up with the Taylor rule. It set out to determine what the federal funds rate should be using various inputs including an assumed rate of R* of 2%. The Taylor rule worked for a while but started to show much higher numbers than the actual federal funds rate and people gave up on it in the early 2000s.

Then a couple of Federal Reserve (Fed) economists thought “We can do better” and came up with a new version of R* in 2001. It was immediately used by the Fed in their monthly meetings. One of the Fed economists was John Williams and he now runs the New York Fed.

The R* rate was published every month up until early 2020 when it gave a reading of zero and the real fed funds rate was -1.2%. Rather than have such a discrepancy, the New York Fed thought it best to work on the R* more and wait for a better time to revive it.

Well, they did, and this week we scraped the new data. Here’s the new R*:

Source: Federal Reserve, Cerity Partners’ calculations

We won’t put up a “before and after” but would make the following points.

  1. The original R* was lower in the 2009 to 2020 period than the revised 2009-2020 data suggesting it underestimated growth that entire time.
  2. R* was around 2.5% higher in the post-GFC world than actual rates. The Fed kept rates at zero for nearly a decade while inflation ran at around 2%.
  3. It started to move up in the 2020-2021 Covid-19 years suggesting it was quite a good indicator of the demand rush and supply problems we saw in 2021. Fed funds rates were around 3% to 8% below what the R* said they should be.
  4. It would also suggest that the second rounds of policy stimulus were pretty aggressive. Higher inflation, therefore, was inevitable.
  5. The revised R* implies that the Fed should have started raising rates earlier than 2022 and more slowly (yay, agree with that)
  6. The current fed funds rate is 5.25%, the last core PCE inflation was 4.6% and the last core-CPI rate was 5.5%. The real Fed Funds rate is thus somewhere from 0.25% to 0.6% and the R* is 1.2%.
  7. Some may argue that the Fed Funds rate is too low. We don’t because inflation is falling and the R*, ahem, moves around a lot, as the chart clearly shows.

Ok, so if we don’t really care about R* and the Fed freely admits it’s “very imprecise and subject to real-time measurement error”, why are we talking about it?

  • One, because it at least provides insight into whether current rates are way off. If R* was 4%, the current yield curve would probably not look like it does now.
  • Two, it’s higher now than in the low growth period of 2009 to 2018 where we were stuck in a 2-2-2 rut, with 2% inflation, 2% growth and the 10-Year Treasury barely above 2%. And real wages grew a miserable 5.5% over 11 years, or 0.5% a year.
  • Three, the lower the growth, the lower the R*. If it’s now higher than the 2009 to 2020 decade, then…great. That means we have more growth to look forward to.

R* may seem theoretical and more of interest to philosophers than market practitioners. But to us, it’s a good sign that the Fed is willing to see a stronger growth period which requires a higher R*. That’s at least good for savers, who’ve had to put up with low rates for 13 years. We look forward to the next R* report. It comes out quarterly, so we’ll let you know.

It Takes a While for Inflation to Fall

There’s been no shortage of Fed speak this week with two broad camps of “hike more now” and “pause”. The Fed’s announcement from the early May meeting changed the wording from

The committee anticipates that additional policy firming [i.e., rate hikes] may be appropriate…”


In determining the extent to which additional policy firming may be appropriate…”

That may not seem much of a change but the Fed chooses its words carefully and the inference was, “Oh, they’re going to pause.” The subsequent press conference didn’t change anyone’s mind.

Since then, we’ve had a good jobs report and expectations have risen that there may well be a further hike in the June 13th meeting. In the May minutes, published this week we saw that the staff expect a recession in 2023, that tighter credit conditions will make life harder for households and small and mid-sized banks and “almost all participants [in the meeting…saw upside risks to inflation” while a “few’ saw “downside”  risks.

History would suggest the minority is right. Here’s a chart showing the headline inflation and the core-PCE inflation which is usually what the Fed targets.

Source: FactSet

The takeaway is that inflation takes a while to decline. Some parts of the economy are very rate sensitive with housing being the most obvious. Rates go up, mortgages go up and home sales decline. Then a few quarters later, spending on home furnishings and appliances begins to drop. The latest sales numbers for furniture and home sales are down 9% over the year and, a year ago, existing home sales were down 19%. That all makes sense. If you bought a house a year ago, you would have some budget for improvement and changes (remember these are existing homes so some things just gotta go). But a year later that budget is probably spent. More here on the Home Depot call.

Other parts of the economy, however, are less rate sensitive and inflation falls more slowly. Inflation, for example, does not dramatically change demand for services and basic goods. Prices for those items are driven more by supply, not interest rates. They’re often called “sticky” prices and they’re about 60% of core CPI.

The chart below shows that inflation tends to go up quickly and fall slowly. We took the peaks of each inflation period and measured how long it takes for inflation to fall from its peak to its cyclical low. Here it is:

Source: FactSet

It’s not a quick drop! In most cases, it takes around 24 months for inflation to fall from its peak to trough. It took longer in 1991 but the 1990s were an exceptional period of globalization and major deflationary forces. Peak inflation in this cycle was in June 2022 and it’s been falling steadily ever since. We’re only 11 months into an inflation drop that typically takes at least twice as long to reach trough. You feel like saying “Wait up, will you? It’s a $26 trillion economy….it lags.”  

As we’ve noted before, the Fed’s hikes over the last year are some of the fastest ever. There have been 10 moves in 15 months, including three hikes of 0.75%, which was last done in 1988. In other words, the Fed delivered a lot, quickly.

The Fed should stop now and let inflation cool, as it almost inevitably will. An increase in June risks sending the economy into a deeper recession than it already forecasts. We hope the Fed sticks. We’ll know in two weeks.

The Legend of Zelda

We wrote last week at some length on the future and outlook of the Japanese economy and stock market.

The quick bull case is that i) companies seem ready to embrace new shareholder-friendly attitudes, like share buybacks, ii) inflation is up (which is a good thing if you’ve had over 30 years of deflation), iii) the Tokyo Stock Exchange has put into force some serious guidelines for companies that don’t keep their share price above book value, iv) households can invest up to $140,000 in equities, where income and capital gains are tax-free, up from $107,000 in 2022 v) real wages are up 4%, the fastest level in over 30 years and vi) it’s a cheap and less risky way to invest in China, because of the two countries’ strong trade links of around $25 billion a month.

The bear case is i) yep, heard all that before ii) taxes will have to rise to fund sizable deficits iii) inflation will run too hot and iv) the Bank of Japan Governor Kazuo Ueda may have trouble changing and managing the vast amounts of central bank balance sheet purchases.

We’ll keep you posted. Anyway, this section is about this:

Source: © Nintendo.

It’s Nintendo’s new version of a franchise created in 1986 and went on sale two weeks ago. It’s a game (and apologies to all gamers here for the explanation) in which a young person called Link, pairs up with Princess Zelda to combat an evil warlord who wants to use the Triforce, a blend of physical and mystical powers, for very bad ends. If that sounds all Lord of the Rings, meets Excalibur crossed with Japanese folklore and medieval history, then the author would agree with you.

The game retails for $70 and fits into a Switch console that runs $480. No one knows how long it takes to finish but the best guess is that it would take 51 hours to go through it one level at a time and 207 hours to visit the side stories.

The quality is stunning. It took six years to develop and was delayed a year. But as one of its developers said, “A delayed game is eventually good, but a rushed game is forever bad.”

If you’ve ever seen a Miyazaki film, especially Princess Mononoke, imagine something with more detail, a multiple-layered world, flying, over 100 speaking characters, rockets, robots, goddesses, wisdom and numerous adventures within adventures.

Nintendo has sold 125 million Switch consoles since 2017 and 56 million copies of the Zelda games. The new “Tears of the Kingdom” sold 10 million units in three days, making it the most successful game launch ever and bigger than most Hollywood blockbusters.

We mention it because Japan somehow seems relevant again. Nintendo has opened its second Nintendo World at Universal Studios. The Super Mario Brothers Movie grossed $1.2 billion since opening in April. Micron Technology is expanding in Japan, as are Taiwan Semiconductor and Samsung. Part of that is to diversify away from Taiwan but also because Japan is very business friendly these days.

That’s all good news but investors remain underweight in Japan and require more proof that the corporate and investment world is on the move. But with the new Zelda game, it seems Japan can still produce high-quality, world-class products for which people will pay premium prices. Now, where’s my Switch?

Debt Ceiling

We’re going to cheat a little and update a note we sent out earlier this week during the debt negotiations (he says through clinched teeth because if these had been the norm in 1919, we’d still be around a table in Versailles). If you read it earlier, you can skip this bit.

Where are we?

The U.S. Treasury is weeks away from running out of money. The U.S. government debt limit is $31.4 trillion and the total amount of debt outstanding is $31.4 trillion. The only reason the U.S. Treasury has not stopped issuing net new debt in the last few months is because Treasury Secretary Janet Yellen says the U.S. has taken “extraordinary measures.”

There are three “extraordinary” measures:

  • One, withholding crediting the $292 billion “G-Fund” in the Thrift Savings Plan (a sort of 401(k) plan for government employees).
  • Two, postponing investments in the $965 billion Civil Service Retirement and Disability Fund, which pays benefits to retired federal employees.
  • And three, reducing cash held at the $17 billion Exchange Stabilization Fund, which is used to remit overseas aid and balance any exposure the U.S. government may have to foreign exchange payments.

In each case, the U.S. Treasury effectively wrote IOUs and will credit each account when it’s able to borrow more. The sum of all three extraordinary measures is around $230 billion and there’s probably not much left of that for the U.S. Treasury to access.

Once those sources are tapped out, the U.S. Treasury has two remaining sources of cash.

  • First is the Treasury General Account, which is where one federal agency, say Customs, deposits excise duties, and another, say Defense, makes payments to contractors.
  • The second is the daily inflows of tax receipts, which vary a lot depending on the time of the year but are about $14 billion per day in May of 2023. The U.S. Treasury then makes payments every day which in May they averaged about $25 billion a day. The U.S. thus runs a budget deficit and the shortfall is what the U.S. Treasury needs to borrow from the public.

As of May 23, 2023, the special measures are running out. Tax receipts are coming in, with some big ones coming in early June, and payments are going out. As long as the payments are greater than the receipts, the U.S. Treasury needs to borrow and if it can’t, it either has to stop repaying bonds or cut spending.

What payments does the U.S. Treasury have to make?

We know most of the transactions every day. For example, on June 1, 2023, the U.S. Treasury must make a $47 billion payment to Medicare, a $12 billion payment to retired military personnel and a $12 billion payment to the Veterans Benefits Administration. It also must pay $25 billion every Wednesday to Social Security beneficiaries and $6 billion to federal employees. From June 5th to June 9th, it must also pay Medicare around $21 billion. On the revenue side, the big inflow will be the week of June 15th when $206 billion come in and $100 billion goes out.

Some days the U.S. Treasury receives in taxes what it pays in benefits but generally the inflow is less than the outflow. Normally, the U.S. Treasury would then borrow the difference. The payments the U.S. Treasury makes, whether wages, benefits, or interest payments are fixed, legal and binding. The “X-date” is simply the day when those obligations are all due. But… without enough revenue to cover them. For now, let’s stay with Secretary Yellen and assume that day is June 1, 2023.

What happens then?

The U.S. Treasury can do one of four things:

  1. Prioritize payments: This simply means one of two things. One, the U.S. Treasury pays bond holders ahead of everyone else. Or two, payments are delayed until there’s sufficient money to cover all bills. The U.S. Treasury has stated in very clear terms that it does not want to do either.
  2. Issue never-used securities: These include selling a trillion-dollar coin or issuing perpetuals (coupon only bonds, like Strip IOs with no maturity) or high coupon notes. We’ve discussed them here and here but they are not relevant today.
  3. It ignores the debt ceiling and carries on like nothing happened. This is the 14th Amendment clause.
  4. It defaults

Let’s go with number four as it’s the only option that doesn’t run into unprecedented legal problems.

The U.S. Treasury will not default in the normal sense of the word. The U.S. is capable of and willing to pay all its bills. It does not have a credit problem.

But there is a risk of a “technical” default which is what happens if a principal repayment is not made, usually within three days of the due date. In this case, the U.S. Treasury and holders of Treasury bills (T-Bills) would come to an agreement of when and how to make full repayment.

If that happens, holders of bills maturing in early June will not receive their principal. They would then wait until the Treasury had enough money to repay the bill. Note, we’re only talking about Treasury bills, which are short-term securities issued below par value and repaid at par. So, if the Treasury issued a bill a year ago at $97 and now repays it at $100, the $3 counts towards the debt ceiling. Coupon bonds, issued from 2 years to 30 years are issued at $100 and repaid at $100. So, a maturing existing coupon bond does not count towards the debt ceiling and is simply rolled or reissued. That’s why we will see plenty of issuance of bonds and bills even if the debt ceiling is not lifted. It’s simply debt being rolled over. For today’s purposes, we’re only talking about the risk to T-Bills.

If you’re now holding a T-Bill that the Treasury won’t repay at par, the options are to sell it or wait. Back in 2011’s debt drama, the Fed said it would buy T-Bills at face value but have kept quiet this time round.

Again, we would stress that a technical default is not a great look for the U.S., but investors will be repaid in full. They will not lose money.

What happens to bills held by money market funds? Are they safe?

Many money market funds have moved out of bills maturing in June. There are $769 billion of bills maturing in June and money market funds held $103 billion in April. It’s almost certainly lower now as money market funds mostly hold longer maturities than one-month bills. The same money market funds also deposit cash with the Fed overnight in return for holding bills. The bills they hold overnight are returned to the Fed and are considered very safe and liquid.

Are money market funds safe and not subject to default risk?

Yes. We believe money market funds will remain liquid and priced at a $1 net asset value (NAV). They have a lot of flexibility to hold different maturities and can always borrow from the Fed. This applies to government and Treasury money market funds. Ultra-short bond funds and some prime money market funds may have a floating NAV.

How worried are markets?

We’ve measured several of the obvious market stresses in the last few weeks. The list included credit default prices, Treasury auctions, the U.S. dollar, all sort of Treasury spreads and stocks with high exposure to government revenues. The one that showed the most worry was the short-term bill rate. First, here:

Source: FactSet, Cerity Partners’ calculations

We showed this last week and it shows every Treasury Bill maturing between now and November. The dots in the top left-hand corner are all bills that mature in June and last week they yielded between 5.3% and 5.5%. They’re now between 5.4% and 6.2%. The yields fall rapidly in mid-June because there will be a sizable tax payment on June 15th.

Then there’s this:

Source: FactSet

It shows the 1-Month Treasury bill yielding more than the fed funds rate, which hasn’t happened since 1-Month bills were first issued in 2001. It’s not a great look but some money market funds are probably selling just to avoid marking a bill below its $100 face value. It’s not strange under the circumstances and will probably revert very quickly once a settlement comes.

Sum it up, please.

Here are the seven likely scenarios over the next week.

Source: Cerity Partners’ calculations

Our base case is that there will not be a default and there will be some bargain that either suspends or increases the debt ceiling. The main unknown is whether it’s a short-term fix, for say, six months or extends to beyond the 2024 election. Or somewhere between those two dates.

What are the investment options now?

  1. Maintain a cash position in the portfolio. Please consult your Cerity Partners advisor but we can offer cash management services and investments into Treasury bills beyond the June period, which we believe carries the higher risk.
  2. Consider money market mutual funds, either government-only, agency or Treasury money market funds. Also consider using municipal money market funds for taxable accounts.
  3. Consider investing in longer-term, 5-to-10-year Treasuries. If there is a technical default, longer-term bonds will be more attractive, as indeed happened in 2011. Again, please check with your Cerity Partners advisor on the appropriate Treasury and other asset holdings for you.
  4. We would not sell equities. It is highly likely that the Fed would step in and either stop raising rates, lower rates or suspend the selling of Treasuries and mortgages on its balance sheet. It would seek to rebuild confidence with easier monetary policy. That is usually a good time for equities.
  5. Avoid timing markets. When the debt ceiling was resolved in 2011, stocks rose 23% in the next six months. When the 2013 debt ceiling was resolved, the market rose 10% in the following six months.

Here is a summary of the above under different scenarios.

Source: Cerity Partners

Markets are nervous and another day without progress adds to the sense of unease. However, we know this:

  1. U.S. companies just reported solid earnings, often surprising analysts with better numbers than expected.
  2. Overseas markets, especially in Japan and Europe have had a good start to the year.
  3. The Fed is nearly finished on further rate hikes.
  4. The long end of the bond market has been strong this year and remains stable.
  5. The main economic indicators, such as employment and services, are weaker but not signaling any sharp recession.
  6. The U.S. Treasury and dollar are highly regarded. A worst-case technical default is highly unlikely to diminish their market strength or standing.

We consider an intentional default highly unlikely but will continue to monitor developments and advise on any changes

The Bottom Line

The debt ceiling was one of those Banquo ghost moments except instead of a short interlude went on all week. As of writing, each side is digging in. So far, so exactly like the past debt negotiations.

This week stocks had trouble bouncing past the 4,200 level and were down 1.2%. Nvidia reported and gave a very bullish forecast on AI-related chip sales. Its value is knocking on the door of the $1 trillion club, along with Apple, Google, Microsoft and Amazon. Stocks are not worried about the debt ceiling. Perhaps they should be but the good news overrides the fear element.

European stocks have held up well but there was some concern that the U.S. market is cooling for luxury goods. Stocks like Louis Vuitton, Hermés and Richemont were down 3% to 5%. These are some of the most valuable companies in Europe with a combined market capitalization of over $1 trillion.

The economic news was thinner on the ground but GDP for the first quarter was revised up to 1.3%. Past readers will remember that the Gross Domestic Income (GDI) number also came out and should be the same as GDP. But they’re often not and this time the difference between the two numbers was $380 billion and GDI fell 2.3%. Usually, those numbers end up meeting in the middle which would mean the economy is running slower than the Fed thinks. We’ll keep you posted.

Other than the bill market, Treasuries, bonds, stocks and the dollar seem unfazed by the debt ceiling. That may be nonchalance, a blind spot or “we’ve seen this movie before” but that could turn if things develop badly. Meanwhile, Fitch Ratings put the U.S. debt on “negative watch”. They still list the U.S. as an AAA borrower but if you take a read of the press release, they sound fed up with the whole thing.

And who can blame them?

Subscribe below for our investment updates.

Art: Mickalene Thomas (b 1971)

Please read important disclosures here.