The Recession Paradox | Alfonso Peccatiello

Episode Summary

Executive Summary: Alfonso Pecatiello argues the U.S. avoided recession in early 2023 because monetary tightening works with long lags, especially after 2020-21's credit boom. He distinguishes between bank reserves and real-economy money, saying actual money creation comes mainly from fiscal deficits, bank lending, and non-bank credit. He expects recession risk and bond outperformance to rise by late 2023/early 2024.

Main Topics: Delayed recession from monetary tightening (Priority: 5/5): Pecatiello says 2023 H1 felt like 'waiting for Godot' because the recession he expected never arrived, but historical lags from the yield curve inversion suggest the economy is only now entering the danger zone. Credit channel and refinancing lags (Priority: 5/5): He explains that the main transmission mechanism is tighter credit, but 2020-21 borrowers locked in long maturities and low rates, delaying the impact of higher rates on households and corporations. What counts as real money creation (Priority: 5/5): He draws a sharp distinction between bank reserves and money available to the private sector, arguing that real economy money is created through fiscal deficits, bank lending, and non-bank credit expansion. Quantitative easing and portfolio rebalancing (Priority: 4/5): QE creates bank reserves and financial deposits, not direct spendable money, but can trigger portfolio rebalancing into risk assets and easier credit conditions over time. Why stocks rallied despite QT and higher rates (Priority: 4/5): He argues simple one-variable models like net liquidity or Fed balance-sheet changes do not reliably predict equities; equities can rise during QT if growth surprises higher and recession fears fade. Bond outlook and recession hedging (Priority: 5/5): With disinflation and slowing growth, he sees a window for bonds to outperform equities over the next six months and recommends cheap optionality to hedge against recession or credit stress.

Key Arguments: The economy is not red-hot, but real growth around 1% annualized is inconsistent with recession and reflects below-trend growth after tightening. Yield curve inversions typically take 13-21 months to feed through to recessionary conditions; the current cycle is around month 13, so the risk period is just beginning. The 2022 slowdown was partly inflation-driven, not purely rate-driven; falling energy prices since late 2022 helped growth rebound. Credit transmission has been delayed because households and corporates locked in low-cost, long-duration funding in 2020-21, reducing immediate refinancing pressure. A single bank can face deposit flight, but at the system level bank lending still creates new deposits and therefore real economy money. QE mainly changes the composition of financial assets and reserves; it does not itself create spendable money for households or firms. High-frequency narratives like 'QT means stocks down' are too simplistic; stock returns depend on multiple variables, growth surprises, and valuation. Bonds can still work in a disinflationary soft-growth environment, especially as recession probability rises and optionality becomes more attractive. Short-dated recession protection/calls became cheap again after the banking crisis, making hedges more appealing relative to the market consensus. Based on historical lags, recession risk should peak around late 2023 to early 2024, which is also when bonds may begin outperforming equities on a volatility-adjusted basis.

Data Points: NBER-style real growth: ~1% annualized - Current seven-subindicator real growth level used to assess recession risk Yield curve inversion lag: 13-21 months - Historical window between 2s/10s inversion and recessionary forces Yield curve inversion start: May-June 2022 - Approximate time when the inversion began in this cycle Cycle month of inversion: Month 13 - Point in time when the discussion takes place Mortgage rates: ~7% - Current mortgage rates restraining marginal new borrowers Locked-in mortgage rates: ~3% - Many households refinanced during 2020-21 at very low rates Corporate bond duration: 6 years to 9-10 years - Average issuance duration lengthened in 2020-21, delaying refinancing BBB corporate yields: ~6% for 10-year BBB debt - Roughly 100 bps higher than the 2015-2019 pre-pandemic period Bank credit share of total private credit: ~40% - U.S. bank credit as a share of total private-sector credit creation Non-bank / other credit share: ~60% - Remaining share of private-sector credit from capital markets, shadow banking, etc. Credit impulse peak: Highest in 20 years - Q4 2020 reading boosted by fiscal transfers and cheap credit S&P 500 EPS growth in 2021: ~40%-50% YoY - Lagged effect following the 2020 credit impulse surge Credit impulse decline: Fell sharply through Q1 2023 - Real credit creation for the private sector deteriorated materially Credit impulse stabilization: Improved on 3M/6M annualized basis in Q2 2023 - Still weak, but less negative than earlier in the year Core services ex-housing inflation: 1.4% annualized (3M) - Recent sticky-inflation measure Powell cares about 10-year real rates in 2016/2019: ~0% - Compared with growth conditions similar to today 10-year real rates today: 1.65% - Higher real yields despite similar growth, keeping policy tight Fed funds in 2006: 5.25%+ - Example used to show high rates can coexist with equity strength Fed funds in 1999-2000: ~5.75%-6% - Used to argue high policy rates do not mechanically prevent bubbles Net liquidity model explanatory power: R² ~3%-10% - Correlation of changes in bank reserves/liquidity with S&P 500 returns Credit impulse explanatory power: R² ~15%-20% - Correlation of credit impulse with changes in earnings and equities 2024 EPS estimate: +11% - Market optimism despite tightening lags still to come QT pace: $95 billion/month - Current Fed balance-sheet runoff pace referenced in discussion

Pivotal Quotes: "Waiting for Godot." — Alfonso Pecatiello: His description of the first half of 2023, with the expected recession not arriving "Real economy money printing happens only in these three conditions." — Alfonso Pecatiello: He summarizes his framework for money creation: fiscal deficits, bank lending, and non-bank credit "Those are the four pretty expensive words in finance where we're going to say, well, credit doesn't matter." — Alfonso Pecatiello: Warning against dismissing the credit channel because markets have stayed resilient

Implications: Listeners should expect tighter policy to matter more with a lag, making late-2023/early-2024 a higher-risk window for growth and credit. Bonds and recession hedges look more attractive, while simplistic liquidity-based equity calls remain unreliable.