Political Calculations
Unexpectedly Intriguing!
August 23, 2019

Imagine an old fashioned weather vane, one that has an arrow that points in the direction the wind is blowing that pivots about a point in the middle of the arrow.

Now watch the following video, which involves a mathematically sculpted, 3D-printed design by Kokichi Sugihara to execute a pretty cool optical illusion.

HT: Mark Perry.

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August 22, 2019

A quote from Charles Dickens' A Tale of Two Cities seems an appropriate introduction:

It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness, it was the epoch of belief, it was the epoch of incredulity, it was the season of Light, it was the season of Darkness, it was the spring of hope, it was the winter of despair, we had everything before us, we had nothing before us, we were all going direct to heaven, we were all going direct the other way - in short, the period was so far like the present period, that some of its noisiest authorities insisted on its being received, for good or for evil, in the superlative degree of comparison only.

Let's start with an update to the Recession Probability Track, which is based on Jonathan Wright's 2006 paper describing a recession forecasting method using the level of the effective Federal Funds Rate and the spread between the yields of the 10-Year and 3-Month Constant Maturity U.S. Treasuries, where we will see the early effects of both the Fed's quarter point rate cut that was announced on 31 July 2019 and the recent inversions of the U.S. Treasury yield curve, which has seen long term rates fall below short term rates.

Recession Probability Track, Starting 02 January 2014, Ending 21 August 2019

Using Wright's recession forecast model, with an average Federal Funds Rate of 2.33%, an average 10-Year constant maturity Treasury yield of 2.01%, and an average 3-Month constant maturity Treasury yield of 2.16% over the last 91 days, we find the probability that a recession will eventually be found to have begun between 21 August 2019 and 21 August 2020 is 11%, or rather, a 1-in-9 chance of a recession starting before September 2020.

That's the 'best of times' outcome, which would appear to be backed by the sunny outlook indicated by Credit Suisse's latest update to its U.S. recession dashboard:

Credit Suisse U.S. Recession Dashboard, 21 August 2019 - Source: CNBC

Economic data looks nothing like that of a recession, according to Credit Suisse.

The firm created a “recession dashboard” in which the firm tracked the state of seven main economic indicators at the start of each recession dating back to 1973. In past recessions, most of the indicators were “recessionary” or “neutral,” while the current state of the economy is telling a different story.

“Key signals such as labor and credit trends remain quite healthy,” said Credit Suisse’s chief U.S. equity strategist, Jonathan Golub, in a note to clients Tuesday.

But there's potentially a problem here for assessing the probability of a future recession in today's economic environment. Because Wright's model was developed using historic data from before the Great Recession, it doesn't consider factors like quantitative easing or quantitative tightening in its assessment, which can achieve effects similar to what would happen if the Fed either hiked or cut U.S. interest rates, without changing the level of the Federal Funds Rate itself.

When the Fed implemented its various quantitative easing monetary policies from 2009 through 2015, this effect was measured as the "shadow Federal Funds Rate", which became the primary means by which the Fed sought to stimulate the U.S. economy after it cut the Federal Funds Rate all the way to a near-zero level. By May 2014, these policies delivered the equivalent of an additional three percentage point reduction in the Federal Funds Rate while it was nominally held between 0% and 0.25%.

After May 2014, the Fed reversed this stimulative policy, which might be called quantitative tightening. Several analysts have indicated they believe quantitative tightening added the equivalent of three full percentage points to the nominal Federal Funds Rate before the end of 2015.

After that, the Fed hiked the Federal Funds Rate several times before the rate officially rose to its target range between 2.25% and 2.50%, which lasted until 31 July 2019.

But that wasn't the Fed's only method of conducting its quantitative tightening policies. In late 2017, the Fed began actively reducing its holdings of debt securities issued by U.S. government entities, where some analysts estimate that each $200 billion reduction in the Fed's balance sheet has the equivalent effect of a 0.25% hike in the Federal Funds Rate. Collectively, the Fed's balance sheet reduction quantitative tightening program from September 2017 through July 2019 would have the equivalent effect of increasing the effective level of the Federal Funds Rate by an additional 0.8%.

The following interactive chart shows how these analysts perceive the effect of the Fed's quantitative tightening programs to the U.S. economy has played out since they began in May 2014, as if the Fed had only raised the Federal Funds Rate from its near-zero level at that time. If you're reading this article on a site that republishes our RSS news feed, please click here to access a static version of the chart.

When we substitute the peak QT-adjusted Federal Funds Rate of 6.2% from July 2019 into our recession odds reckoning tool, using the same average 10-Year and 3-Month U.S. Treasury yields we used in the update to the Recession Probability Track above, we find the adjusted probability of recession starting in the U.S. sometime in the next 12 months is 54.5%, or rather, or slightly better than even.

Whether that's the correct way to account for what what the Fed does in the shadows through its quantitative tightening policies remains to be determined, but the extent to which the Fed's policies have an effect on the economy does explain why investors are betting the Fed will be forced to engage in a series of cuts to the Federal Funds Rate and to also restart its quantitative easing programs to mitigate the effects of a new recession to which its policies are believed to have contributed.

That was an interesting alternative scenario to consider for forecasting the probability of recession in the U.S. during the next 12 months. If you have a particular recession risk scenario you would like to consider, please take advantage of our recession odds reckoning tool.

Meanwhile, if you would like to catch up on any of the analysis we've previously presented, here are all the links going back to when we restarted this series back in June 2017.

Previously on Political Calculations


August 21, 2019

How big is the U.S. Federal Reserve's balance sheet? What kind of assets does it hold? What is the value of those assets?

Three questions, the answers for which we've presented in the following two interactive charts! In the first chart below, we show the value of the major asset categories the U.S. Federal Reserve has held on its balance sheet in each week from 18 December 2002 through 14 August 2019, which provides the data needed to answer all three questions. [If you're accessing this article that republishes our RSS news feed, you might consider clicking through to our site to access a working version of the interactive chart, or if you prefer, you can click here for a static version.]

Our second chart presents the same data, but this time in a stacked area format, which makes it easier to find the answer to the first question of how big the Fed's balance sheet has been from 18 December 2002 through 14 August 2019. [Click here for a static version of this second chart.]

Starting at 18 December 2002, the Fed's balance sheet consisted mainly of U.S. Treasuries, which grew from $629 billion at that time to roughly $800 billion in late 2007. The onset of the Great Recession saw the Fed's balance sheet crash to a level of roughly $450 billion by mid-2008, after which the size of the Fed's balance sheet inflated in three major phases through its quantitative easing monetary policy, in which it sought to prop up government supported agencies such as Fannie Mae and Freddie Mac by buying bonds these entities issued to support their operations (Federal Agency Debt), while also buying up the Mortgage Backed Securities these institutions issued to prop up the U.S. housing market. At the same time, the Fed also funded the U.S. government's deficit spending by buying copious amounts of U.S. Treasuries.

By January 2015, the combined amount of all these assets averaged roughly $4.25 trillion, which the Fed held stable at this level until late 2017, when the Fed began actively reducing the amount of its balance sheet holdings through its quantitative tightening monetary policy. Through 14 August 2019, the combined total of these three major asset categories fell to $3.6 trillion, $625 billion less than the average level it held from 2015 through most of 2017.

If we use Morgan Stanley's estimate that each $200 billion reduction in the Fed's balance sheet has the equivalent effect of a 0.25% hike in the Federal Funds Rate, the Fed's active balance sheet reduction quantitative tightening program since late 2017 has had the equivalent effect of increasing the Federal Funds Rate by an additional 0.8% over its official target range of 2.25-2.50% through the end of July 2019.

On 31 July 2019, the Fed acted to cut its target range for the Federal Funds Rate by a quarter percentage point and to suspend its balance sheet reduction program, effective 1 August 2019.


U.S. Federal Reserve. U.S. Treasury Securities Held by the Federal Reserve: All Maturities. [Online Database]. Accessed 17 August 2019.

U.S. Federal Reserve. Federal Agency Debt Securities Held by the Federal Reserve: All Maturities. [Online Database]. Accessed 17 August 2019.

U.S. Federal Reserve. Assets: Securities Held Outright: Mortgage-Backed Securities. [Online Database]. Accessed 17 August 2019.

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August 20, 2019

Every three months, we take a snapshot of the expectations for future earnings in the S&P 500 at approximately the midpoint of the current quarter, shortly after most U.S. firms have announced their previous quarter's earnings.

The earnings outlook for the S&P 500 has weakened since our Spring 2019 edition. The projected trailing year earnings per share for the index in December 2019 has fallen from the $150.96 forecast three months earlier to $146.63 this month.

Forecasts for S&P 500 Trailing Twelve Month Earnings per Share, 2014-2020, Snapshot on 15 August 2019

The oddest thing about this chart is the projected boost to earnings for 2019-Q4. We don't know any reason why Standard & Poor's trailing year earnings is so optimistic in this quarter after deflating so much in the quarters preceding it.

Looking at that optimism even further out, expected earnings for the S&P 500 at the end of 2020 have also weakened, but by a smaller amount, falling from $167.97 to $166.51 per share, where S&P is projecting a sharply upward trajectory.

You can see in the chart how those projections turned out during 2018 and 2019. These will almost certainly be revised downward, sharply, in upcoming quarters.

Data Source

Silverblatt, Howard. Standard & Poor. S&P 500 Earnings and Estimates. [Excel Spreadsheet]. 15 August 2019. Accessed 16 August 2019.

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August 19, 2019

For a week where the full U.S. Treasury yield curve inverted as stock prices were quite volatile, the week didn't end all that much differently than the previous week did.

By the end of the week, the S&P 500 (Index: SPX) was about one percentage point lower than a week earlier, as investors continued splitting their forward-looking attention betweeen 2019-Q4 and 2020-Q1. And while investors flirted with focusing more closely on 2019-Q4 during the week, there wasn't enough in the news to shift it more fully onto that particular point of time in the future.

Alternative Futures - S&P 500 - 2019Q3 - Standard Model - Snapshot on 16 Aug 2019

At this point, investors are betting the Federal Reserve will be forced to act aggressively to cut short term interest rates in a bid to revert the yield curve, with the CME Group's FedWatch Tool now projecting as many as four quarter point rate cuts in the four quarters ahead:

CME Group FedWatch Tool Probabilities of Federal Funds Rate Changing at Future FOMC Meeting Dates, Snapshot on 16 August 2019

We think the uncertainty of the timing of rate cuts between 2019-Q4 and 2020-Q1 is what is holding investors' attention on these two future quarters for now, but the potential deterioration of economic circumstances that would lead to the increased probability of rate cuts extending into 2020-Q2 could spark a much more negative reaction in stock prices should investors have reason to really focus on that particular future quarter.

There's also the potential that changes in the expectations for dividends in any of these upcoming quarters will have an impact on stock prices as well. Fortunately, dividend futures have so far been largely stable, where much of the outsized volatility we've seen may be attributed to investors shifting their time horizons in setting their expectations.

That's why we make a point of tracking the market moving headlines each week, which we've presented below. The random onset of new information plays a large role in setting the forward-looking focus of investors.

Monday, 12 August 2019
Tuesday, 13 August 2019
Wednesday, 14 August 2019
Thursday, 15 August 2019
Friday, 16 August 2019

Looking for the bigger picture of the week's news than the headlines we've noted above? Barry Ritholtz lists seven positives and only five negatives in the week's economics and market-related news.

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