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The markets are closely watching the Federal Reserve, which in turn has its eyes on the federal government to see how tariffs, taxes and policy impact inflation and the economy. The May 6-7 Federal Open Market Committee meeting could be the one where rate cuts resume. Join us May 8 at 1 p.m. as Luke Tilley, chief economist at Wilmington Trust, breaks down the meeting, Chair Powell's press conference and what may lie ahead.
Transcription:
Transcripts are generated using a combination of speech recognition software and human transcribers, and may contain errors. Please check the corresponding audio for the authoritative record.
Gary Siegel (00:10):
Hi, and welcome to another Bond Buyer Leaders event. I'm your host Bond Buyer Managing Editor Gary Siegel. Today we're going to discuss the Federal Open Market Committee's meeting and monetary policy. My guest is Luke Tilley, chief economist at Wilmington Trust. Luke, welcome back and thank you for joining us.
Luke Tilley (00:32):
Thanks for having me back on Gary.
Gary Siegel (00:35):
So I want to tell the audience if they have questions, they could put them in the q and a queue. Don't wait for a specific session because we're going to take questions as they come up, not at any specific time. So Luke, is there anything statement or Fed Chair Jerome Powell's press conference that surprised you or grabbed your attention?
Luke Tilley (01:01):
Well, I think the first thing that I think got the market's attention but shouldn't be too surprising was that the FOMC statement said that the uncertainty had increased and the risks of inflation and the unemployment rate had gone up. And I mean if you just think about the timing of the meetings from March until May, you've had obviously the so-called reciprocal tariffs and then the delays on those and some other, you've got more economic data since then and I think it would all point towards that. So I don't think it was very surprising in terms of what came out of the statement, but it really does point to, and then Chair Powell's press conference emphasized all of this that their job has basically gotten harder. They've got one tool, two goals, and those two goals, there's the risk of the going further away from both of them. And I think that that was really the focus of the day and the focus of the meeting and what he ended up talking most about. So I'm not really answering your question. What's the thing that either surprised you're something, but that's clearly the situation right now is that it could go either way and they don't know which way it's going to go and they have to wait and see how events play out as much as they do the economic data. Gary,
Gary Siegel (02:22):
So you mentioned that they have one tool and two goals. Will that one tool be sufficient In this case it looks like employment is okay for now, but inflation is still too high.
Luke Tilley (02:38):
Yeah, so it's interesting. I'm actually, I don't even know if it's in this case. So sort of at a fundamental level, and this gets a little bit more on the wonky side of things, if you have one goal, I'm sorry, one tool and two goals, then by construction it's sort of a challenging situation. So this is going back and this again talking at a high level but also going back to the last time they changed their operating model structure, it must have been 2018 or 2019, it was before the pandemic. They essentially came out and said something along the lines of we've got one tool, we've got two goals and inflation, we've got a little bit more control over. The labor market is not really affected as much by our tools. So at times when they are in conflict with one another, we're going to try and fix the inflation thing with the knowledge that if we get that right, then the labor market will work itself out.
(03:37):
And it's almost like even though Congress has given them actually in a very technical manner, and this is probably for a different session, they have a three part mandate. Everybody says they have a dual mandate, but as well as I do that technically from Congress is a three part mandate, but they're basically kind of not sidestepping but saying to Congress, okay, you gave us this two mandate because of the way our tools work, we're going to favor one over the other. And they said that back in like I said, 2018 or 2019. And in the current situation they're following through on that I think which is Chair Powell saying we have to watch how far each of them get away from their different goals and really talking in very high level abstract terms because he doesn't know which way they're going to go. But I would expect that if inflation were to move higher and get farther away from the goal that that's the one that would get the most focused.
(04:28):
They don't want inflation to run away. That's sort of the lesson of monetary policy from the 1970s and eighties. Now to the question of right now, yeah, I think that that would apply too here because as people asked him and as he said, there's not a whole lot that interest rates can do to fix tariff problems or supply chain problems or any of the policies that are coming out. They're not really designed for that. The interest rate is designed to affect demand and it's not going to fix those problems. So there's the first problem, one tool, two goals, they kind of sidestep it or say that we're going to focus on one more than the other. And then in the current environment it's sort of hard to address the issues that are going on right now. So a very long answer to a short question, which is what I tend to do, that's how I'm thinking about it. Gary.
Gary Siegel (05:19):
That's perfect. Long answers are good. So my sources are very much split between no cuts this year, possibility of a rate hike this year to four cuts this year. Where do you stand on monetary policy this year?
Luke Tilley (05:38):
Well, as a prelude on January one, we thought four cuts this year is where we were. We were very, very, very far out of consensus and I would get a lot of sideways looks around the office here for a little while there. And we've moved deeper than that now, more like 125 basis points of cut. So what is that? Seven? So as the market moved towards us, we've moved even further away. But let me address, I'll address the second part of that where we are now. But first in the lead up and when we thought four cuts at the beginning of the year and the consensus was like zero or one and the fed was saying 50 basis points, maybe the key difference and the key issue was the relative strength of the consumer and we did not think the consumer was strong enough to handle the kind of tariffs that were being talked about or even less tariffs than were being talked about.
(06:38):
So we didn't think that inflation was going to be a problem even if the tariffs came in. Now we didn't expect them to be as high as they are now, but we didn't think that inflation was going to be a problem. And the way that I usually talk about this is that if you imagine you're walking down the street, you worked in New York City for a lot of years, you're very busy, you're walking down the street and you're walking at a pretty good clip and it's so crowded and somebody is also walking fast and they bump into you from the side. You are like, okay, well I've got a good head of steam but I've got good balance and I'm okay. And I think of that as the consumer's just charging along and then here comes tariffs and kind of knocks you, you're okay. This was the narrative at the beginning of the year that consumer would be fine, wouldn't get knocked over by this person bumping into them.
(07:23):
It'd be like a little bit of a speed bump and that the consumer could take on these tariffs and have sort of high inflation. And the way that we were viewing it at the time was same thing walking down the street, but right before that person hits you sort of trip on one of the cracks in the sidewalk or something like that. So you've already lost your balance and then the person hits you, boom, you're going down. And that's why we were thinking four cuts at the beginning of the year because when we looked at the consumer spending data in the fourth quarter, it already looks like people were front running tariffs. It's durable goods, it's cars. In October, November, people were replacing storm damaged cars from late last year and the market narrative was look at the strong consumer look how charging down the sidewalk.
(08:07):
And we were looking at it going, oh my goodness, the consumer's actually in trouble. Look at credit card delinquencies, look at what's going on. And that was just tariff front running. And the biggest change from January to March fed meetings was I think that realization when you looked at consumer sentiment, when you look at all of those things, when you see the slowdown in spending retail sales, we know the consumer was slowing down now and the market narrative has now moved to realizing that the consumer was stumbling going into this. Now as the market had moved to three or four cuts, we're even deeper than that and it's because now we're expecting a recession, we've got a 55% probability of recession. I'm happy to go through some of the details of just how large of a hit this is as the consumer's already stumbling and then is just getting absolutely nailed from the side by how high these tariffs are.
(08:57):
Even with the trade deal today with uk, I don't think that changes it very much. It is such a big hit that we've moved to a recession call and with that recession call we would think as I think most people would, that you would have the cuts. Oh, and that's the other big difference from January to March is as soon as the consumer data started to weaken the Fed funds futures market started to reflect that, right? It was like, oh no, tariffs are coming, but there were more and more cuts priced in, so it was sort of endorsing that view as well. Gary. So we are, I really don't like the game of how many cuts this year because the length of the year keeps changing. It's 125 basis points for us this year. I always think of it as like 12 months ahead. Sometimes I miss whether like, oh, is that cut in December or is it in January? But we're at 1 25 and calendar year 2025 right now.
Gary Siegel (09:51):
And when do you think they'll start?
Luke Tilley (09:55):
Interesting. I thought that after the jobs report that it was going to have to be punted to July because we had June and I thought I was going to have to move it, but I'm actually holding on to June right now. It could just as easily move to July. And so this is interesting. I'm going to look over here and it's because I'm reading from this screen. This is the thing that I prepared to talk about at the March meeting. I had thought it was going to be May and then I had to punt it and because fed chairs are never going to tell you exactly whether they're going to be thinking about a meeting or not, but he got very close on March 19th when somebody asked him, sorry, standing here today, would you be surprised to pivot back towards rate cuts in May? It wasn't having anything to do with it.
(10:44):
Chair Powell said, I think we're not going to be in a hurry to move. And as I mentioned, I think we're well positioned to wait for further clarity, not in any hurry. That's it. That's all he said. And I can remember sitting here at this desk going, okay, may is off the table. He's never going to say off the table, but he said May is off the table yesterday. Yesterday, yeah, yesterday. So when you say you don't need to be in a hurry, does that mean that the outlook can change it away? That your stance could be warranted? A changing your stance could be warranted as soon as your next meeting? This you've already read this chair Powell's answer. As I said, we're comfortable with our policy stance, we think we're in the right place and we'll have to see how things evolve. We don't feel like we need to be in a hurry.
(11:27):
We feel like it's appropriate to be patient when things develop. And of course we have a record we can move quickly when that's appropriate. I mean I only read you half of the answer. It keeps going and saying basically he's not taking it off the table. I don't know if it's enough, I don't think, because the next job report is most likely going to be much weaker than April. Next thing we should talk about the jobs report and why it's not a surprise that the hard data is staying strong, but he didn't take it off the table. So it could be June, it could be July. I think the larger issue, I don't think that hard about seven week increments, but I think the bigger issue is the economy is in our view, expected to weaken and then we're going to start getting those rate cuts and they're going to be trying to provide that accommodation. Gary,
Gary Siegel (12:17):
Are you more concerned about economic growth or inflation?
Luke Tilley (12:21):
Oh, economic growth, absolutely. And this goes hand in hand with expecting cuts at the beginning of the year. Inflation is not a problem. It's not a problem at all right now and it hasn't been for a long time. The overall PCE is at 2.3%. Core PCE is at 2.6% and it's really only above target because of shelter. And probably most people who would be watching this are very familiar with the lag. We've seen home prices have slowed to normal rates, rents have slowed to normal rates and then we have to wait for the inflation figures to come down. If you just do the entire inflation basket on a PCE basis and just remove shelter, the fed's been at target or below target for 14 or 15 months. I mean consumers are not out there shopping in a way that's driving prices higher. And with the CPI, it's ridiculous, it's like 18 or 19 months that they've been below target.
(13:19):
But if consumers are challenged as we think stumbling along the sidewalk, they're not driving up the prices of things. And when they get hit by these tariffs, which are, if you apply, everybody does the effective rate thing. If you apply the current tariffs to 2024 trade numbers, it's a 780 billion hit. It's 2.6% of GDP. It's like nine and a half percent of retail sales. It's a massive hit that's not going to drive inflation. It's going to drive up the prices of imported goods, which is a very different thing from inflation. Inflation is broad price increases, and if consumers are facing those kinds of challenges because of the increased price of imported goods, then services, they're going to spend less movies, less haircuts, less airline trips, less trips to amusement parks, and you'll get import prices going up, services prices on the weaker side. And then as you move into a recession, you've got the economic growth problems and then inflation's going to go down anyway. So definitely more worried about economic growth. Gary,
Gary Siegel (14:20):
The last GDP read was negative, was that a blip or do you expect another bad quarter ahead?
Luke Tilley (14:31):
I expect another bad quarter. I guess by definition if I'm saying that I think we'll go into recession. I mean the last GDP was negative and for good reason. It's because consumers and firms turned away from domestically produced products in order to import a lot of stuff. And the imports, half of them went into inventories. Maybe 20 to 25% of 'em were consumers loading up on cars and other durable goods. And then business CapEx side was a lot of front loading as well. The investment in computers and servers and things like that, say 60% annualized increase. I mean it was a massive crush of hey, we got to get more computers and everything before the tariffs hit. And I don't think that there's underlying strength behind that. We had people will say imports subtract from GDP, they don't really subtract from GDP. It's just like the math of it.
(15:31):
If you're trying to figure out how much stuff you made, like this big pile of stuff you made and you say, oh wait, we imported some of that, it's like, well, okay, take the stuff out of the pile that we imported. How much stuff did you make there it is. So take away the stuff you imported. It is not like it doesn't detract from GDP, it's just you don't want to count it If you're counting up the stuff that you made and the stuff that we made in quarter one declined by the 0.3%. Our sales of domestic product, how much we made in sold either here or overseas went down by two point half percent. It hasn't been that low since Covid and the global financial crisis. So we've got weakness there. I mean overall demand was strong. We were buying a bunch of imports and buying some domestic stuff in terms of frontloading, but it looks mostly like frontloading to me. And I think it's, we might get a little bit of help if other countries started frontloading some of our stuff in the second quarter, but that's the only thing I could see mitigating it. Gary,
Gary Siegel (16:35):
So tariffs and tax policy, which President Trump advocates could spike inflation. No one knows for sure what will happen with tariffs. What's your best guess, how likely are these to be implemented as currently stated and what is your take on the impact of these moves if implemented would have?
Luke Tilley (16:56):
Yeah, this is where I think, hey, this is how we get to the recession expectation and the market is reacting to the good news when you strike a trade deal or when there is good news or good words from President Trump or from President Xi on the China front. But if we take a very big step back and let's say we strike trade deals with all of the countries that were listed in the rose garden as being special and singled out special in a negative way. Even then as we've seen with the UK, at least the reporting that I've seen so far, is that tariffs go down to 10% the baseline tariff. And I think I did read, but I can't confirm that that's the deal with the UK. It's going down to a baseline tariff of 10%. Let's say all of those countries get trade deals and they go down to 10%, China's going to be different. Let's pick a number. They go from 145% down to a baseline tariff of 25%.
(18:02):
If that was the case, and I'm not even saying that's an expectation, I'm saying that that would be a case that would have the markets like celebrating. You're still talking about a quintupling or sex, I don't know, whatever the numbers are for a five or six or seven time increase in your effective tariff rate, that's a pretty hefty tax hike. So I think, and that was our debate here for a very long time is is the 10% baseline tariff a ceiling or a floor? The more that I see it looks more and more like a floor. And if that's the floor then that's a challenge. And for the Fed, again, going back to the previous question, I don't think it generates inflation. It'll generate what looks like in inflation for a few months in CPI and PC as it hits those imported goods. But the economic impact would be to pull everything back down so I don't see them as inflationary. You mentioned, I'm sorry, you had also mentioned tax policy in the beginning of the previous question, but then it sounded like it was about tariffs and I'm not sure if I answered your full question.
Gary Siegel (19:07):
Well, the next question is going to be about tax policy. Alright, so do you expect the tax exemption to survive in the negotiations or are we going to see some cutback in tax exemption?
Luke Tilley (19:24):
Which tax exemption are we talking about here? Bonds. Oh, I would think it would survive. So I'm not a policy expert, but that seems to be one of the things that even if some of the people in the administration who are not really close to this would be advocating, well you got to get rid of that or something. That's the kind of thing that would start hitting markets in a way that would make our treasury secretary very uncomfortable. In the same way that on April, I guess it was ninth that Wednesday, April 9th when there were so many challenges in the bond market that he was able to go into the Oval Office and say, something needs to happen here. And I think that those kind of market signals are pretty clear to the Treasury secretary and to several other people in the administration. And I just think that there are enough interested parties that it would end up being an exemption. They're going to look for revenues and ways that they can get the tax cuts in every way that they can. So I'm sure it's being examined, but I wouldn't expect that to disappear. But again, not a policy expert. I'm more of an economist who is calling the balls and strikes not predicting where the pitcher's going to throw it.
Gary Siegel (20:35):
Very good. So Luke, how serious is the Fed about hitting 2% inflation? Would they be satisfied with 2.5%?
Luke Tilley (20:46):
I mean they're serious about it. Just ask 'em. And I say that kind of jokingly because that's always going to be the first thing that they say, we are committed to our 2% objective and they should be absolutely 100%. And I think that their actions right now, PCE is at 2.3% and they've been holding rates since whenever the last time the cut was December. But that sort of reflects that as well. But I say it kind of cheekily at the beginning because I just can't imagine a fed share that would clobber the economy over the head for 2.3 or 2.5% inflation. It's not that damaging. And this is where you do get to the interplay of is inflation more of a problem or is unemployment more of a problem? Because 2.3% PCE where it is right now is not a problem at all as long as consumers and businesses are not expecting it to move higher. If long-term expectations are in check 2.3% PCE inflation is completely fine. I think yes, they're committed to two, but they're not going to, I don't think they're going to force a recession if they truly think it was going to stay at 2.3 or 2.5 or something like that, even though they would never really say that out loud.
Gary Siegel (22:09):
We know that the neutral rate is an estimate and there's no definitive number. What is your estimate of the neutral rate and how do you think it compares with the fed's estimate?
Luke Tilley (22:23):
Oh, we use the 2 75 to 3% as neutral and it's like what's the number that you never actually get to just keep going through it to the upside and to the downside. And it is really important not just because where do you end more important is how much pressure are you putting on the, how hard are you pressing on the breaker? How hard are you pressing on the accelerator right now? And that has been a lot of the debate has been, oh, if the neutral rate is actually higher, then we're not as restrictive as we think and that's why inflation is not going down, inflation is going down, it has been going down, like I mentioned, it's really just that lagging shelter thing and consumers are not pushing inflation higher. So I think of it as 2.75 to 3%. The Fed very publicly doesn't know where it is and the wide range of estimates of the longer run federal funds rate is pretty clear that there's a difference of opinion of how high or low it is. But I think they're, oh, I should know this right off the top of my head, but I think that the median person on the FOMC is right around where I am unless they moved it a little bit higher in the last set of forecasts.
Gary Siegel (23:46):
Is the yield curve worth watching for clues about recession
Luke Tilley (23:55):
Worth watching? Yes. Dispositive? No, it is definitely not. And over the past couple of years, especially in 2022 where I never really expected that there was going to be a recession, I mean in a very mechanical way, the inversion of the yield curve is not predicting recession, it's predicting the Fed is going to cut rates. That's the more relevant or the more concrete statement about the inversion of the yield curve. Now it so happens to be the case that usually they cut rates when there is a recession and that's why that relationship turns up in academic studies. I think it was Rick Michigan, the former governor, maybe even the former vice chair who turned this out in the paper in the late 1990s, like, hey, you should look at the inversion of the curve. But I don't use it as an everyday tool of predicting whether there's going to be a recession or not. It is absolutely relevant because pointing to those expectations of future fed policy and obviously all the other things that are baked in like future inflation and economic growth. So it is relevant but not dispositive
Gary Siegel (25:09):
Other than fodder for the press to ask Jerome Powell about what is the impact of the poor relationship between Powell and President Trump,
Luke Tilley (25:22):
What is the impact makes for good TV and articles? So I usually come at this from I think a different angle from most other people, or at least the narratives that I see and the way that people ask me questions are, is the Fed going to cut rates because of the pressure from the White House? And I don't think so. I don't think so at all. I think it's actually the opposite. I think that they're less likely to cut rates. And I worked there, I worked at the Philadelphia Fed for six years and the most remarkable thing to me about the institution is how dedicated people are to that goal and to anybody who works and you've got bank examiners, there's payments people, there's so many people who work in the Fed. We're usually in this discussion, we just work on the interest rate side and the monetary policy side.
(26:22):
And the overriding view across that institution that I heard for six years was people need to trust that the Fed is going to try to achieve the target of the 2% inflation. That's the biggest asset of the Federal Reserve, is that trust. And the Fed will always, in my mind, take action to preserve that trust. So the moment you cave to a president, well that causes a lot of challenges. If people don't trust that inflation is going to stay low, then you lose track of the goal that you're trying to, the goal that you're trying to achieve. So very, even if you're just dedicated to your mission, then you would try to take actions to make it easier for you to do your job. And that's that part of the answer. The second part of the answer is complete speculation and armchair psychology. I mean I've met Chair Powell several times, but not enough to know what goes on in his head, but also I'll do it from the standpoint of me the Fed is full of lore and icons and the hundred year history that I was there for when they general, you can go to this website, the Fed history that they generated in 2013 when I was working there and the culture of all the things that have happened to the Fed over the a hundred years and if I was the Fed chair right now, so there's this big Fed treasury accord 1954 I think, where basically the Fed was being pressured to support treasury issuance and they didn't want to do it.
(28:04):
So you get this fed treasury accord, they made this big agreement and the people at the time are enshrined and they've got their, they're remembered. If I was the fed chair and I had already navigated the economy pretty well, I think through a covid environment and that sort of thing. I mean the only other thing that you could do to boost your own reputation would be to preserve the independence of the Fed in the face of immense political pressure. So if I was in the job and I was interested in preserving the Fed's independence and my reputation, I would dig in, I'd be less likely to cut even if the data was marginal. It's like maybe you should cut, maybe not be like, let's wait so we're not caving to pressure. Sorry, another long answer and that calls for a lot of speculation, which is sort of outside the realm of my job.
Gary Siegel (29:02):
That's quite alright, so I'm going to shift to the questions from the audience. What has changed to make the Fed's job harder?
Luke Tilley (29:14):
Oh, easily the tariffs, and I don't mean that as a political statement. I mean it is an exogenous force that comes in from the outside. So the Fed is full of economists who have learned econometrics and relationships and they've written papers and models and they've done all kinds of econometric studies. If the economy goes up by this much, then interest rates need to go up or down by this much. And if the exchange rate goes up, then that means this for interest rates and it's all based on these historical relationships behind things in the macro economy. And if you have something like tariffs, which is this big exogenous change to the structure of the economy, then in some way you have changed the value of those coefficients or you've thrown out the value of the coefficient. So it's like, okay, we've got all these models.
(30:03):
Oh no, somebody broke the models and that's the real challenge. That was the real challenge with Covid. That was the challenge with stimulus payments and the stimulus checks and all of that kind of stuff is it's all this external stuff. The housing crisis, 2006, seven and eight, even the financial crisis, you're still kind of following the internal workings of an economy and how those coefficients work. Things like covid stimulus payments and tariffs, they kind of break your coefficient so then you're not flying blind but your instruments are really foggy. And that is I think the biggest challenge for the Fed right now is they just don't, and not just tariffs but the immigration policy possibilities and regulation, those are lower level than the tariffs, but basically it's that their instruments have gotten a little bit foggy.
Gary Siegel (30:51):
Luke, is the supply shock real in terms of shelves will be empty or is it more realistic for consumers to change buying patterns? Trump claims maybe children only get $1 instead of three for the holidays.
Luke Tilley (31:10):
So this is a really good question and it's posed in sort of a binary way. Are the tariffs going to cause a problem of shelves being empty or not? And where the answer is somewhere in the middle, it's like president says one doll instead of three. It's absolutely material and I know that because that's what I read and that's what I hear from retailers and everybody that you've got this challenge with ordering ahead of time basically holidays, big events, things like that. I said to my wife recently, I'm like, have you heard that if we don't start out ordering these Halloween costumes right now and it's going to be much harder to find a Halloween costume now nobody has three Halloween costumes. You usually just do one, but maybe people will be making more at home this year. So it's not like binary if the costumes don't show up and there's not enough of them, you won't have Halloween, you'll just have a lot more homemade outfits.
(32:07):
I worry, I worry a little bit about that, a little bit about things not being available, but customers will shop for something else or they'll be creative. I worry a little bit more about integral pieces that are needed to make something work. Like if a car is all set to go except for those last few pieces like we saw during the pandemic, if you need those semiconductors to make that car work. Otherwise it's just sitting and you have these hordes of cars sitting on a lot somewhere, not on a lot yet, but in a manufacturing facility waiting for those last pieces. That's the kind of supply chain issue that I think is bigger than dolls or a specific toy or Halloween costumes or something like that. And those are the kinds of supply chain issues that can end up creating more problems. Gary,
Gary Siegel (32:57):
What is the expectation for high yield in a recession and credit spreads and potential defaults
Luke Tilley (33:06):
In a recession? I mean it obviously depends on how deep it is and when I say we're expecting a recession, I think a mild and fairly shallow recession, which would mean in that instance you do have the unemployment rate going up less and less solvency on the consumer side, probably higher risk premiums being demanded for high yield and you'd have some more challenges in the markets that way. So I would think, and incidentally I'm on our investment committee too, not just economists, and recently we had made a change because high yield spreads had not really gone up all that much and investment grade had gone up almost as much. And so there was this relative attractive trade that you could get similar yield for not as much risk. So we did a little bit of a shift there and I think that move is emblematic of the uncertainty of the recession right now, but I would think that those spreads would move up and you'd have some weakness even though we're calling it a mild and a short recession, but we're not expecting financial crisis or seizing of credit markets. So much has changed with banks and the amount of capital that they have with emergency facilities from the Fed. So we're not expecting blowouts and crisis mode.
Gary Siegel (34:38):
All right. We have a follow up on that question. Audience member says he believes credit spreads now are kind of in the middle of the historical road. Should we be seeing some more wider spreads?
Luke Tilley (34:56):
It depends on the way that the economy goes, so I don't know what we should be seeing, but if we move toward, and let's see here. If you want to try to map spreads to current economic conditions, which is maybe you should do, maybe you shouldn't, but I think the Bloomberg survey of economists of which we participate, the median person is a 45% chance of recession right now. We had moved to 55 we're I think it's the few contributors to that survey that have an actual recession and that's material because an economic slowdown would widen spreads and it increases risk and whatnot, but you don't really get the unemployment rate moving up in a more of a contractionary situation. If the consensus view moves towards a recession, I think you would get higher yields from there or the actual realization of a recession and you would get higher yields from there. But again, that statement is contingent on that view and sort of the baseline view of the realization of that. We're saying that we expect a recession probability of 55%, but that also means we have 45% of no recession. So I think that they would move higher if we end up being right about that.
Gary Siegel (36:10):
Next question from the audience, won't the 8 trillion in commitments from corporations building and moving manufacturing greatly help with economic growth along with the tariff deals to contribute to lowering the U.S. debt?
Luke Tilley (36:27):
They could for sure, and I don't think that I've said anything that would argue against that, and a lot of my job is the next nine to 12 months for our investment committee to make tactical decisions over the next nine to 12 month period. We are looking into sort of the long-term feasibility of moving a lot of manufacturing back here and sort of what would help and would it boost the economy and what are the impacts of that would be and it's less relevant to my day-to-day work, which is basically to call the economy over the next nine to 12 months. So I don't even take that strong of a view on the question that was asked. Obviously it matters if something would end up helping our debt, sort of our longer term structural allocation, but most of my days are spent on our tactical allocation and you could move towards the end point that President Trump would like to in a different way.
(37:29):
He could have said, we're going to have these tariffs, they're going to be this high, we're going to go into increments of X over each month for the next two years. We'll subsidize industries that want to move their manufacturing here, and you could have had a slower move towards that endpoint. I'm not saying you should have done that. I'm saying it would be a different way to get to the same endpoint that would be less disruptive. So when I talk about a recession, it's not like a value judgment on the tariffs and whether they're good, bad or indifferent, I'm just an economist. Again, the umpire saying, Ooh, this is going to be really challenging. And because it's such an immediate shock, even with trade deals, again, I'm saying even with trade deals, if we have a 10% baseline tariff and 25 on China, that is still an immense shock to our system. So I say recession, it really doesn't have much to do with whether moving manufacturing here is good, bad or indifferent. And then to the broader question, would it end up helping with our deficit? Oh, I don't remember for the question, sorry Gary. Was it I was assuming fiscal deficit, but maybe it's trade deficit.
Gary Siegel (38:37):
I didn't say,
Luke Tilley (38:38):
Oh, I was about to start answering from a fiscal deficit and I was sort of trying to figure out what I was going to say, but maybe it's implying to a trade deficit,
Gary Siegel (38:47):
No lower U.S. debt. So I think it's general.
Luke Tilley (38:51):
Lower US debt. Okay. I don't know that it would have a big impact on lower U.S. debt. I mean if you want to move manufacturing back here, okay, I don't really have a view on that, but you're going to be giving up something else. So the first lesson of economics, right? If you want something and you increase one thing, then you have to give up something else. I don't know what we're giving up. I don't know if it's healthcare jobs, I don't know if it's retail jobs. I don't know if it's we have to get more people or more CapEx, but you have to give up something somewhere else and I would have to know a little bit more about what we are giving up over if we have a longer term more manufacturing here to really answer whether it changes the debt or not. I don't really think of it in terms of debt for the debt. It's like, okay, what are we going to do about social security? What are we going to do about Medicare? What are we going to do about some of those other things? Spending, basically
Gary Siegel (39:47):
The next question is what is the impact of a falling dollar on your interest rate prediction and what about sale of treasuries from foreign investors on your predictions?
Luke Tilley (39:59):
Yeah, I very much believe and sort of endorsed what has been described as the sell America trade over the past couple of months, which is again, not a value judgment, it's just if you've got a president and administration that says we want to have less trade, we want to make more stuff here, we want to have, maybe he's not saying less trade, but we want to have more manufacturing here and I guess they're less globalist or whatever the term would be. It's more independence, it's less global trade. Then you do have people who are on the margin less interested in US equities either because of profitability reasons or what have you, get less interest in the dollar and less interest in treasuries, and those should all make longer term interest rates moved up. And that's sort of baked into some of our expectations when we get a little bit further out.
(40:53):
Right now, we have fairly low interest rate expectations both at the short end and the long end because of the recession call over a nine to 12 month period. But you definitely would have higher interest rates because if you're more insular, you've got less dollars going overseas, less people buying treasuries. The second part of the question that's about sales by other countries. Yeah, I don't think it's like a nefarious, China could spike our rates if they sold a whole bunch, but they'd be hurting themselves quite a bit too. Japan is the largest owner of our debt. China's about the same as the UK actually. Actually, yeah, China's about the same as the UK and I guess I don't think as much about a nefarious action or somebody trying to hurt us. I think more about all of those countries and how much they want to hold dollars, right?
(41:48):
China has a bunch of treasuries because we buy stuff from them, we send dollars over there, somebody over there wants you on. So they go to their central bank and say, here are some dollars. And they buy treasuries with it and they do want to hold onto them. And I think about if you have less trade with that country, they're going to buy less because receiving less dollars in terms of trade, but also shops like the one that I'm sitting here, which is in Pennsylvania and international investors and everybody. If you're looking at what's going on in the world in the US changing its desire to have open trade with the rest of the world, then in some ways you're going to have people who, whether they're domestic or they're international, wanting to be owning probably less treasuries. So I guess I just think about it as less like one actor, one country selling a whole bunch of treasuries and more like everybody who holds treasuries deciding to hold three to 5% less. That is more at the fundamental nature of higher long-term interest rates after all is said and done.
Gary Siegel (42:53):
Do you think that an anticipated China trade deal is already partially baked into market and do you expect that a Chinese trade deal to will bring material benefits to the U.S. economy?
Luke Tilley (43:06):
The first part of the question, yes, a trade deal is baked in. I don't want to say I know what would actually happen if the market was baking in 145% tariff on everything from China and what are they on US 125 or something like that. If that was baked in and everybody thought that that was permanent and it was going to stay, then I think markets would be a lot uglier right now. So in that way, I think that a trade deal is in some way baked in. And if we strike a trade deal with them, I think it would be helpful compared to where we are now. But the real question is where do we end up? And if it ends up at let's say 25% baseline tar on everything from China, then I mean it could end up helping things in the long run. This is again, the long run versus the short run thing. The short run thing is a ton of disruption. I mean, we import 435 billion worth of stuff from them last year. Some of them critical components. It depends if semiconductors and phones are still exempted, but it would be even if you go from 145 on China to 25, it's going to be very disruptive in my mind. But I think, I don't know what's baked in right now, but it's not the status quo.
Gary Siegel (44:26):
Luke, we have three more questions. You have time to answer those?
Luke Tilley (44:30):
Sure. I'm going to charge you the same amount no matter how many questions you ask me, Gary.
Gary Siegel (44:36):
Excellent.
Luke Tilley (44:36):
I'm kidding.
Gary Siegel (44:38):
I know. Are there any insights small businesses should be focused on to whether the current tariff of environment
Luke Tilley (44:51):
I had have a hard time? I've never run a small business. I've never run any kind of a business. My in-laws did. I know how challenging it can be, and I definitely don't have advice. Do I have any insight? My insight would be that everything that I've already said, I expect these trade deals to come out. If we have what I think now to be a 10% baseline tariff on all countries as a floor, then if I was running a small business and I had a supply chain that relied on internationally produced goods, then you'd have to be thinking about flexibility because it's not going to be the same for every country. This is likely to go on for a while, but I don't know how it's going to turn out. And the other thing that is very much in my mind as part of my job, and I guess small businesses would be thinking about it as well, is that most of the news right now is about those individual trade deals with individual countries, but does not mean that we're not going to get semiconductors as a separate tariff labor later on, pharmaceuticals as a separate action later on.
(46:02):
And so the administration still has a country by country thing going on then, but also industries that it's very interested in and it just means a lot of uncertainty. So I don't know if that's inside or not for a small business, but it's how we're looking at it with our lens.
Gary Siegel (46:19):
Will immigration and loss of lower wage paying workers eventually drag down growth in hospitality and service industries?
Luke Tilley (46:30):
So right now we're still getting a lot of job growth from leisure and hospitality and it looks like for the most part we have that labor available. It would appear because we don't have the wages moving up in that sector and the jobs are being filled. Still a fairly strong point of growth, but the overall labor market has slowed down quite a bit in terms of churn, hiring and firing. So we've had a lot of reductions of encounters at the border and a lot less immigration are trying to cross the border. So right now, things seem to be okay and I wouldn't expect disruption for leisure and hospitality if the administration is ever able to follow through on what they expected, which was getting rid of all illegal immigrants. It's about eight and a half million I think that are estimated to be in the workforce that would be incredibly disruptive for leisure and hospitality. So I think the question was something like, would you see a contraction there or you would see a lot of industry change, like less people working higher productivity, not making the beds as often, something like that if it's hotels and restaurants would have to adjust as well. So I think it would be pretty disruptive if you get to the point of moving those illegal immigrants out of the country, but we haven't seen that yet.
Gary Siegel (47:52):
Last question, Luke. How long do you think the U.S. long-term interest rates will stay at the current levels and when do you think these high levels become a serious debt servicing concern for the us?
Luke Tilley (48:05):
Oh, they're moving up today, four 40 on the tenure, our long term. So when I talk about our longer term structural asset allocation that we set at the beginning of 2023, January, 2023, we said it, we were using for a 10 year yield, the long-term equilibrium rate, four to 4 25. So we were expecting never to go back to the 20 teens between the global financial crisis and pandemic. What was the average like two and a half percent or something like that for the 10 year yield? We never expected it to move back there. After covid, we had a reset higher. That's why I'm saying when we did the longer term rates, we were four to 4 25. So my immediate reaction to the question is longer term rates are about where we are expecting right now post tariffs and whatnot. They could be higher like four and a half to 4 75 as the long term. So I'm not thinking of them as currently being that far away from what we think of as the equilibrium. Gary, what was the second part of the question? I was very focused on, oh, are they higher or are they not? Or were they not?
Gary Siegel (49:22):
One second.
Luke Tilley (49:24):
If they higher than. Oh, you marked it as answered.
Gary Siegel (49:29):
When will they become a serious debt servicing concern for the U.S.?
Luke Tilley (49:37):
Oh yeah. They are a debt servicing concern. They're a debt servicing concern if we have three and a half percent because we are not set up to bring in as much as we're paying out. I mean, unless we get a huge boost in productivity growth, economic growth births or immigration, our economy is not set to handle our debt at even a hundred basis points lower than it is right now. We do not have a good long-term outlook for debt and serviceability so incrementally as they go higher. This is a challenge and it's a challenge in the last CBO report that I looked at, congressional budget office, they were using 4.1 or 4.15, so we're a little bit departed from that. But even if it was lower than or a little bit higher, it's a similar situation. It's very challenging. I wish we weren't finishing on that, but the current rates are not that far off of what we have or what the CBO was projecting in the last long-term budget.
Gary Siegel (50:42):
That concludes our Leaders event. I'd like to thank you all for tuning in and my special thanks to my guest, Luke Tilley, chief economist at Wilmington Trust. Have a good afternoon everyone.
