There is a blog post on the site of the New York Fed might be significant. The title of the post is “Has the Fed Stabilized the Price Level?” In the post, the authors take up the question of price level targeting. This, in itself, is worth noting because the debate about whether the Fed should target the inflation rate (trying to hit 2% on the PCE deflator every year) or the price level (trying to average 2% over the next 10 years, say) has been ebbing and flowing for the last few years but during and after the crisis has generally taken a back seat to more pressing issues like “how can we buy a couple trillion dollars’ worth of Treasury and mortgage-backed securities without impairing market function?” Back at the end of 2010, I wrote a blog post about the fact that price-level targeting is gaining currency (no pun intended) at the Fed.
The authors start by noting that the Fed has been incredibly successful, as it turns out, at hitting the 2% target on inflation. Like most authors who address this subject, they choose a historical period where that happens to be the case and draw a nice exponential curve that happens to fit nicely since, after all, they chose a period during which low and stable inflation was the norm. They then proceed, as most establishment economists do, to give the Fed most if not all of the credit for maintaining inflation low and stable even though any fair real-time analysis of the history – see, for example, my book which, incidentally, makes a fine Christmas gift – must conclude that this was partly a lucky break.
What is interesting and potentially significant, though, is where the authors focus on the deviation from that trend. Although drawing the line the way they originally drew it suggests that the Fed has successfully targeted long-term price-level growth almost exactly, they then re-draw the line based on an arbitrary start date of January 2006 (this happens to be the beginning of Bernanke’s tenure, but since the price level in 2006 has nothing to do with actions he took in 2006, that date is purely arbitrary). The significance is that when drawn from that date, the price level appears too low:
“While the price level has remained remarkably close to its 2 percent trend line since the early 1990s, the total PCE deflator has been below this trend line since 2009 with a 1.4 percent gap in July 2013; the core index displays an even larger gap.”
Hmmm. At this point, one suspects that the authors may be adjusting the lens to reach the conclusion they want. They proceed to ask whether the Fed is, or should be, aiming to stabilize inflation (at 2% on PCE, about 2.25% on CPI) or the price level, and suggest (remember, the authors are at the Fed) that quantitatively speaking the Fed’s policy has worked out to be essentially price-level targeting whatever they called it. The big moment comes:
“Moreover, while the FOMC has stated its policy strategy in terms of an inflation rate and not the price level, it is interesting to note that there is a technical equivalence between the Fed’s “longer-run inflation goal” of 2 percent and price-level targeting. As such, if the FOMC’s past behavior continues, it is reasonable to expect inflation temporarily higher than 2 percent so that the price level will return to its long-run trend line.”
Whether or not the Fed actually chooses, or should choose, price-level targeting or rate targeting is a debate for a future day although the link to my blog post above shows it is also a debate for a past day! The interesting thing about the NY Fed blog post, though, is that the price-level argument is being used to support the notion that inflation somewhat above the target is not only acceptable but actually desirable. This may be merely an academic discussion, but take note of it just in case.
The equity melt-up continues, with the S&P 500 now up more than 25% year-to-date in a period of stagnant growth and an environment of declining market liquidity. The catalysts for the latest leg up were the comments and testimony by Fed Chairman-nominee Janet Yellen, whose confirmation hearings began today.
Her comments should alleviate any fear that Yellen will be anything other than the most dovish Fed Chairman in decades. Ordinarily, potential central bankers take advantage of confirmation hearings to burnish their monetarist and hawkish credentials, in much the same way that Presidential candidates always seem to try and campaign as moderates. It makes sense to do so, since the credibility of a central bank has long been considered to be related to its dedication to the philosophy that low and stable prices promote the best long-term growth/inflation tradeoff. Sadly, that no longer appears to be the case, and Janet Yellen should easily be confirmed despite some very scary remarks in both the scripted and the unscripted part of her hearing.
In her prepared remarks, Yellen commented that “A strong recovery will ultimately enable the Fed to reduce its monetary accommodation and reliance on unconventional policy tools such as asset purchases.” Given half a chance to repeat the tried-and-true mantra (which Greenspan used repeatedly) about the Fed balancing its growth and inflation responsibilities by focusing on inflation since growth in the long run is maximized then inflation is low and stable…Yellen focused on growth as not only the primary but virtually the only objective of the FOMC. As with Bernanke, the standard which has been set will be maintained: we now use extraordinary monetary tools until we not only get a recovery, but a strong recovery. My, have the goalposts moved quite a lot since Volcker!
That means that QE may indeed last forever, since QE may be one of the reasons that the recovery is not strong (notice that no country which has employed QE so far…or ever, as far as I know…has enjoyed a strong recovery). In a very direct sense, then, Yellen has declared that the beatings will continue until morale improves. And I always thought that was just a saying!
I would call that borderline insanity, but I am no longer sure it is borderline.
Among other points, Yellen noted that the Fed is intent on avoiding deflation. In this, they are likely to be successful just as I am likely to be successful in keeping alligators from roosting on my rooftop. So far, there is no sign of it happening, hooray! I must be doing something right!
Yellen also remarked that the Fed might still consider cutting the interest it pays on banks’ excess reserves, or IOER. The effect of this would be to release, all at once, some large but unknown quantity of sterile reserves into the transactional money supply. If there was any question that she is more dovish than Bernanke, there it is. It was never clear why the Fed was pursuing such a policy – flood the market with liquidity, and then pay the banks to not lend the money – unless the point was merely to reliquify the banks. It is as if the Fed shipped sealed crates of money to banks and then paid them rent for keeping the boxes in their safes, closed. If you’re going to do QE, this is at least a less-damaging way to do it although it raises the question of what you do when you need the boxes back. Yellen, on the other hand, is open to the idea of telling the banks that the Fed won’t pay them any longer to keep those boxes unopened, and instead will ship them crowbars. This only makes sense if you really do believe that money causes growth, but has nothing to do with inflation.
The future Fed Chairman also declared that the Fed has tools to avert emergence of asset bubble. Of course, no one really doubts that they have the tools; the question is whether they know how and when to use the tools. And, to bring this to current events, the question is no longer whether they can avert the emergence of an asset bubble, but whether they can deflate the one they have already re-inflated in stocks, and an emerging one in property! Oh, wait, she’s at the Federal Reserve…which means she won’t realize these are bubbles until after the bubble pops, and then will say that no one could have known.
Now, it may be that the U.S. is merely nominating Dr. Yellen in self-defense, to keep the dollar from becoming too strong or something. Last week’s surprise rate cut from the ECB, and the interesting interview by Peter Praet of the ECB in which he opens the door for asset purchases (which interview is ably summarized and dissected by Ambrose Evans-Pritchard here), keeps the heat on the Fed to remain the most accommodative of the major central banks.
At least the ECB had a reasonable argument that there was room for them to paint the least attractive house on the block. Europe is the only one of the four major economies (I exclude China since quality data is “iffy” at best) where central-tendency measures of inflation are declining (see chart, source Enduring Investments).
And that is, of course, not unrelated to the fact that the ECB is the only one of the four major central banks to be presiding over low and declining money supply gowth (see chart, source Enduring Investments).
There is of course little desire in the establishment to do so. The equity market continues to spiral higher, making the parties louder and longer. It is fun while it lasts, and changing to a bartender with a more-generous pour might extend the good times slightly longer.
It is no fun being the designated driver, but the good news is that I will be the one without the pounding headache tomorrow.
[Hmmm...erratum and thanks to JC for catching it. The S&P is "only" up 25.6% YTD (my Bloomberg terminal decided that it wants to default to the return in Canadian dollars). So originally the first paragraph had "32%" rather than 25%. Corrected!]
I guess we have to add to the list of uncomfortable comparisons to 1999’s equity mania the Twitter IPO. A widely-known company with no earnings…and no visible way to produce any revenues of note, much less earnings…went public and promptly doubled. Hedge funds which were able to get in on the IPO allocation cheered this nice kick to their performance numbers, and the backers of the now-$25bln-company are surely elated. But the rest of us have got to be thinking about Pets.com.
It was an article by Hussman Funds (ht rich t) that got me thinking more deeply about these comparisons. Although the article was referred to me partly because of the insightful comments about the Phillips Curve, which echo similar comments I have made in the past, I kept reading to the end as I usually do when trapped in a Hussman article! While there are a number of us (including Hussman, Grantham, Arnott, e.g.) who have been concerned for a while about equity market valuations since we use similar metrics, I really haven’t been terribly concerned about the possibility of an imminent and steep market decline for a while, though I think returns from these levels over the next decade will be close to flat in real terms as they were after the 1999 peak. However, Hussman had me thinking about this.
I do think that there is one key difference from 1999, and that is that not everyone is talking about stocks. That is, not yet…the Twitter IPO might get us there – on Fox Business News today a young talking head (who was no more than 10 years old in 1999) made sure that viewers were informed that anyone could buy Twitter, just by calling their broker. (Not just anyone, though, could get in at the IPO price…a point the cub reporter neglected to mention).
The counter-argument to “is this a 1999 set-up?” takes two forms. The less-sophisticated form is “nuh-uh”, although usually said in a slightly more elaborate way that implies the questioner is a mindless, not to mention soulless, Communist who isn’t getting enough loving at home. The more-sophisticated argument is worth considering, but isn’t particularly soothing to me. This hypothesis is that this isn’t 1999, it’s 1997, before the parabolic blow-off and with lots of room left to run. It wasn’t as if there was any lack of skepticism about the stock market’s levels (which, sweetly, we considered lofty at the time):
“Is it possible that there is something fundamentally new about this current period that would warrant such complacency? Yes, it is possible. Markets may have become more efficient, competition is more global, and information technology has doubtless enhanced the stability of business operations. But, regrettably, history is strewn with visions of such “new eras” that, in the end, have proven to be a mirage. In short, history counsels caution.” – Alan Greenspan, February 26th, 1997
The bubble, of course, did not pop in 1997. It popped in 1999, after Greenspan had abandoned his prior skepticism (in late 1998, as he came to believe that “I do not claim that all market behavior is a rational response to changes in the real world. But most of it must be. For, were it otherwise, the relatively stable economic environments that have been evident among the major industrial countries over the generations would not be possible”). Between 1997 and 1999, there was plenty of time for investors to make money, and as long as they realized they were taking money for the future and got out before 2000…alas, very few of them did.
But, speaking from experience, the 1997-1999 period was very lonely. While investors who gradually sold their long positions out in 1998 and 1999 did much better than the ones they were selling to, they were also very unpopular at cocktail parties. The bearish analysts were put on the street, begging for tuppence. Which, considering that most of them were in the United States, was also unsuccessful.
The 1999 bubble…and the later property bubble…also did not burst until the Fed was actually tightening policy. It is on this point that many bullish arguments depend, but it is a weak one I believe. To be sure, there is no chance that the Fed will be tightening policy any time soon. The taper is not going to happen until 2014Q2 at the earliest, and I think it will take until later in 2014, when inflation figures will become uncomfortable, before they will start pulling back on QE. Some observers believe it will be much later. A Wall Street Journal article on Wednesday detailed a recent research paper written by the head of the monetary affairs division at the Fed; it argued that it may make sense for the Fed to lower its Unemployment Rate threshold and said that “an ‘optimal’ policy might keep rates near zero as late as 2017.”
The activist Fed continues to be one of the biggest risks to the market and the economy. As a trader, I know that 90% of trading is just sitting there, waiting for the ‘fat pitch’ you can do something about. It boggles my mind that a central banker doesn’t sit around at least that much, considering that they know even less about the complexities of the global economy than I know about the complexities of the market. And, unlike the global economy, the market doesn’t fight back when I act on it.
I actually have a feeling that we won’t be worrying about those Unemployment thresholds, either the old ones or the ones proposed in that paper. As I wrote late last month, the expansion is getting a bit long in the tooth and I would not be surprised to see another recession looming in 2014. I don’t have any reason for that outlook other than the calendar, but sometimes these reasons become obvious only in hindsight.
In any event, though, I wouldn’t wait around for the Fed to be tightening. It isn’t overnight funding rates that I would worry about, but longer-term interest rates, and there has already been a warning shot fired that indicates the Fed is not wholly in control of those rates.
So, it may be too early to be out of equities. Maybe even a lot too early. But one thing I am sure of is that it isn’t too late. It is the latter condition, not the former, that is the most damaging to one’s financial position.
In one of those “what could possibly go wrong with that plan” moments – which are becoming all too frequent these days – the New York Times this weekend reported that there is “growing concern inside and outside the Fed that inflation is not rising fast enough.”
At some level, this is not exactly new thinking. For decades, economists have argued that “price stability” really means inflation of something just slightly over 0%, because it is assumed to be quite hard to get out of a deflationary spiral. in my view, that’s silly, because simply adding a zero to the currency in everyone’s pocket is a guaranteed way to get out of deflation. It may be that since nudging inflation higher is harder than kicking it higher, the costs of mild deflation are higher than the costs of mild inflation, but I think the jury is out on that question since it isn’t something we have ever experienced. But in any event, this is the reason that inflation in the neighborhood of 2%, rather than 0%, has been the Fed’s implicit or explicit target for a long time.
To the extent that discussion stays academic, it’s not worrisome. Navel-gazing is an occupational hazard of being a professional economist, after all. But now, there are louder and more frequent voices arguing that 2% is too low a target. To see how urgent a problem this is, I submit the following chart, which shows median CPI, along with a horizontal line at 2.25% (roughly equivalent to a 2% target on PCE). Wow, I can see the reason for panic. We are nearly 0.2% below that! And we got within 0.6% of deflation in 2010, in the aftermath of the worst credit crisis in almost 100 years.
I am all for the idea that mild inflation serves to lubricate the gears of commerce, but we should remember that when the CFO of Costco says he likes rising inflation because in that circumstance “the retailer is generally able to expand its profit margins,” that’s good for the equity market perhaps but not as good for the consumer!
It always amazes me how sketchy is the understanding of inflation in a capital markets context by members of the Fed. In the aforementioned article, Chicago Fed President Evans is quoted saying “If inflation is lower than expected, then debt financing is more burdensome than borrowers expected. Problems of debt overhang become that much worse for the economy.” This is absolutely true, but almost completely irrelevant in the current context. Inflation has been lower than a priori expectations since about 1980, which is why a long-nominal-bond position has routinely outperformed inflation. But currently, as the chart below illustrates, 10-year inflation breakevens are at 2.19%. Fully 72% of all 10-year periods since 1914 have seen compounded inflation above that level.
Ten-year inflation swaps, a better measure of inflation expectations, are at 2.52%, which still doesn’t sound like a horrible bet for borrowers. If inflation comes in above 2.52%, the borrower of 10-year fixed-rate money wins; if it comes in below 2.52%, the borrower loses. This is one reason that it is so rare to see corporations issue inflation-indexed debt…they like that bet.
Finally, the article explains that higher inflation allows workers to get higher wages, and gives the example of teachers in Anchorage, Alaska, who just agreed to a contract giving them 1% pay increases for each of the next three years. Since inflation is likely to be above that, the article says, they will be probably receiving a pay cut in real terms. This is absolutely true. (It is also the exact opposite position of the debtor, in that the teachers will do better in real terms if deflation actually happened. Sometimes I just wish the authors of these articles would be consistent.) But this circumstance certainly isn’t helped by inflation; since wage increases tend to trail inflation, real wages tend to lag in inflationary upticks.
None of this represents deep insight from this author. It merely represents that I have at least a rudimentary understanding of how inflation works, and a respect for the damage which inflation can cause to economies, workers, and savers. The fact that this is increasingly rare these days is probably cyclical, and unfortunately is probably a minimum condition for setting up this next inflation debacle. In that context, and with more Federal Reserve economists openly musing about needing to target higher inflation, does 2.19% breakeven sound like a bad deal?
All the expectations for resurgent growth are running into a time problem. While the Federal Reserve continues to pump the system, hoping for that burst of energy coming out of the slump, there is really little reason to expect anything more than we have already gotten. I’ve written recently about that in the context of payroll growth and the rate of improvement in the unemployment rate. But there is also, as I say, a time problem.
The current expansion, believe it or not, is getting long in the tooth. While there have been longer expansions – the one from 1991 to 2001, fueled by a continuous decline in interest rates, a budget that was near balance or in surplus, and an asset bubble engendered by the promise of the Internet and some remarkable Wall Street pitchmen – the average postwar expansion has only been 68 months, peak to peak, or 58 months, trough to peak. According to the NBER, on which we rely to jog our memories since this was so long ago, the prior business cycle peak occurred in December 2007 and the prior trough in June 2009. So, using those average business cycle lengths, the expected date of the subsequent peak would be between August 2013 and May 2014. This latter date is especially interesting because it is approximately the current consensus on when the QE taper is expected to begin (again).
I think it’s not unreasonable to suggest that getting more than an “average” expansion in the current circumstance would be a pleasant surprise indeed. With the size of government deficits, the uncertainty engendered by the morass in Congress and the rapid proliferation of regulatory overhead (both ACA-related and other), real interest rates much closer to the likely bottom than to the likely top, and continued threat of volatility in the international political economy… it is remarkable to me that we’ve even been able to squeeze out one of “average” duration.
And all it took was a few trillions!
It is well past time when it was appropriate for the Federal Reserve to stop trying to push the economy faster. Blowing into the sail simply doesn’t work very well to make the boat go faster. It will only lead to hyperventilation.
So now we are in a situation in which the expansion is likely to begin to wind down, and very likely to do so at least partly provoked by the Fed’s tightening of policy (for lessening QE is, as we have seen from the interest rate response, clearly a tightening of policy). It may become very tempting for the Yellen Fed to continue QE as weakness manifests, but the problem is going to be that inflation is going to be heading higher, not lower, into the slowdown as the housing price inflation continues to percolate into rental prices and a weakening dollar helps other prices to firm as well.
We really are in a very dangerous situation equity market-wise, as a result of this timing issue. Over the next year inflation is going to rise, growth is (probably) going to slow, and equity earnings ex-finance are looking decidedly punk as a recent article by Sheraz Mian from Zacks Investment Research pointed out. Which is not to say, of course, that the stock market can’t or won’t continue to ramp higher…just that it is increasingly subject to sudden-breakage risk as the shelf it sits on gets higher and higher.
The data has started to arrive.
Tuesday’s Employment report (gosh, it seems strange to write that) was weaker-than-expected with Payrolls +148k versus expectations for +180k. As I wrote back at the beginning of August, something in the realm of 200k is about as good as you’re going to get, so we’re not very short of that…we’re just very far short of what the consensus seems to expect we’re eventually going to get. No doubt, 148k isn’t 200k, and the six-month average of 163k is the lowest of the year. But it is also not a calamity, on the growth front.
And yet, 10-year interest rates are 50bps below the highs of early September. (Real yields are actually down 60bps, which means inflation expectations have risen slightly during that period). Interest rates are down because everyone knows that the trajectory of policy, with Yellen as likely to be the next Chairman of the Fed, is going to be “lower for longer.” But why? This goes back to the observation that growth is not far short of the best that it is likely to get. The only point of “lower for longer” is to support asset markets – housing, equity, and the bond market whence our nation’s interest burden is determined – and it seems to be doing this quite well. The alternate theory is that the Fed still fears deflation, despite all evidence (and copious theory) that the risk arrow is pointing in the other direction. In neither case does the Federal Reserve come out looking particularly on top of things, but more and more we are expecting that from Washington whether the officials are elected or appointed.
I really thought at one point that the bond market was going to be where the profligate monetary policy was going to first come unglued, but I am now wondering if it isn’t that denizen of hair-trigger shooters, the foreign exchange markets. The dollar index is plumbing the lows of the last two years, although it remains considerably above the lows of 2008 and 2011. As the chart below shows, the dollar has actually left behind the commodity markets where, as we know, investors suffer from the delusion that growth is more important for the nominal price of commodities than is the overall price level. Weak-ish growth means that commodities are only weakly above its August lows, although the buck is quite a bit lower since then.
I don’t think we can learn much right now watching stocks, where investors are simply playing Icarus. We all know where it leads, but any words of warning are laughed off as they soar with Fed-induced wings. Of course they’ll turn away in time!
I think housing is interesting. Having gotten back barely to fair, or maybe just a smidge cheap, compared to incomes, housing is expensive once again. But it isn’t in bubble territory yet, at least in the sense that when it cracks it could cause the carnage it did once before.
Bonds are on tenuous footing. With the consensus currently in place that the Fed might keep QE in place more or less forever, there are a lot of ways to disappoint the status quo: Fed speakers might suddenly try to start sounding stern again and imply that QE might not last forever; inflation might continue to tick higher and make obvious the unsustainability of the current course; or growth numbers might surprise to the high side.
The barbarians are already overrunning the dollar, and I suspect only the fact that Japanese monetary policy is far worse is keeping the descent slow. But people plugged into the supply and demand for currency are probably most likely to understand what happens when too much is supplied (hint: it’s the same thing that happens to the price of corn when too much corn is supplied). For a while, monetary authorities have been chasing each other to see which could be the least respectable, but it now seems that Japan wins that race and the US is likely to place.
As the chart above shows, reasons for increasing exposure to broad-based commodity indices (especially those that do not overweight energy, as the GSCI does) continue to accumulate.
There is much more data to come, of course, but to me it seems the battle lines have been more or less drawn in this fashion.
Since there is no data of note for a little while, there are some other topics I suppose I have time to remark upon.
I recently read a piece by Morgan Stanley called “Of Dogs, Deflation and Inflation.” In it, the authors essentially argue that the relative stasis of inflation recently is “best interpreted as a balance between inflation and deflation rather than concluding that neither is a material risk. While bold central bank action has been successful in stabilising inflation over the past five years, it has also increased the two-way risk to the future price level – both longer-term inflation and deflation risks have increased.”
If I see a photograph of a golf ball sitting on the rim of the cup, I might conceive of several reasons for that configuration. One is that there are no important forces acting on the ball, so it is sitting still on the edge of the cup. Another is that there are massive forces that are all canceling out: say, a strong wind blowing from right to left, and the golfer using a huge club rather than a putter to put the ball from left to right. Which of these two is inherently more likely? Is it possible that inflation has been relatively stable around the Fed’s target (using Median CPI) because massive quantitative easing just happened to exactly cancel the deflationary forces of the credit collapse? Well, of course it is possible. It is also possible that a derivatives book with two hundred trades in it just happens to have no risk at all. But when you are talking large numbers, it takes extreme precision to balance a system.
So it is more likely that neither force was very strong. However, there is yet a third explanation for that photograph, and that is that the ball was actually in motion and the picture just happens to capture a moment in time. The ball, in fact, proceeded to fall into the cup, but we don’t know that because the picture doesn’t tell us what came after.
This is the situation I believe we are in with inflation in the aftermath of the great recession. There is no doubt that the Fed’s aggressive easing helped ameliorate the deflationary pressures, although I think they were never as great as we thought at the time since the main deflationary pressure came from the decline in money velocity…which was caused mainly by a Fed-induced decline in interest rates. But these two forces, Fed easing and the deflationary impulses from a credit crunch, don’t act simultaneously. The Fed’s action takes longer to materialize in inflationary outcomes…especially when, as in this case, most of the easing from QE was sequestered in sterile bank reserves. We have, though, seen what is happening in the housing market, and it is foolishness to think that this has anything to do with strong household incomes or Congressional support for housing. It is plainly the result of a higher float of money, which has manifested in higher prices for real assets. And that putt was set in motion not this year, but with the earliest QEs that pushed money growth over 10% at times over the years since 2008.
Don’t look at the current state of the ball, that is core inflation, as being a deterministic snapshot. There is a delay between monetary policy and inflation outcomes (the old rule of thumb was 9-12 months, but it was pretty flexible), and that delay is even longer this time around because of the excess-reserves issue. The ball is in motion, and my guess is that the Fed struck the putt too hard.
I haven’t written recently because it is hard to figure out what to do here. Market action at this point seemingly has little to do with fundamentals, and isn’t even in “risk on/risk off” mode because no one seems to be sure how the government shutdown affects risk (the debt ceiling debate is another issue, which I will discuss later).
I often get comments to the effect that “political uncertainty is a fact of life,” or “the Fed always manipulates markets,” implying that we cannot simply refuse to invest because markets aren’t trading cleanly off of economic fundamentals (which don’t directly translate into market action even in the best of times anyway). This is true, but I always hearken back to the notion that uncertainty implies a smaller bet size (a long time ago I wrote an article in which I discussed the implications of the Kelly Criterion for thinking about how one invests). When the economic signals are clear but the market isn’t pricing them properly, then you have a great edge and the market is giving you good odds, and most of your chips should be on the table. When the economic signals aren’t clear, or when stochastic political events are likely to overwhelm them, then your bet should be small because your edge is lower even if you are getting good odds.
In this case, of course, no matter what market you are talking about it isn’t at all clear how the debate (perhaps calling it a “debate” is generous) about the continuing resolution to fund government operations, the ACA, and the debt ceiling will be resolved.
We can speculate about what various outcomes might mean to the markets, but even here our analysis is fraught with uncertainty. Would an extended shutdown be good for equity markets because it would imply a greater chance of lower ACA costs and a lengthier period of Fed quantitative easing? Or would it be bad because of the short-term impact on growth as government spending is delayed? Would bonds rally because there would be no incremental supply, or sell off because of the implied risk of default? A lengthy government closure might be bad for the dollar because it implies more monetary ease, but might be good because it represents “fiscal discipline” (admittedly, in this case it’s discipline in the fetishistic sense rather than in the self-control sense). The only thing I am certain about is the uncertainty, and that spells a smaller bet.
Retail investors are especially at a disadvantage, because of the huge amount of misinformation that is out there about likely scenarios and the results of various outcomes. This misinformation is often unwittingly disseminated by media outlets, but I suspect it is rarely unwittingly initiated by the original sources.
For example, a recent New York Times blog was pretty good at discussing the possible outcomes, but flunked on at least one aspect when it stated what would happen to the economy as a result of a federal default. I don’t mean to pick on the Times here, and in general it is a good article. But at one point the writer said that a default could cause a spike in Treasury yields (likely true), but then continued “The price tag on a huge range of other debt products is benchmarked to the cost of Treasuries. That means a spike in the federal government’s borrowing costs would translate into pricier mortgages, car loans and corporate borrowing costs.”
Well, that’s wrong. It’s not offensively wrong, but it’s wrong (and I’m pointing it out partly as an example of how even simple stuff is confused right now). The interest rate on any nominal debt instrument consists of several components: the real cost of money, a premium for expected inflation, and a premium for the riskiness of the credit. Normally, with Treasuries we can say the credit spread is effectively zero, so that we refer to the spread that a corporate bond trades over Treasuries as “the” credit spread because that spread minus zero equals that spread. But there is no reason to think that spread would remain constant if the Treasury’s credit was diminished, any more than it would remain constant if the corporate’s credit was diminished. If Treasury rates spiked because the government’s perceived credit spread was no longer zero, then unless that also affected the perceived credit of, say, Caterpillar then there is no theoretical reason that CAT yields should also rise.
In any event, a federal default is not going to happen unless someone in the Administration wants it to happen. The government’s $2.9 trillion in revenues is quite a bit more than is needed to pay the $300bln or so in interest costs per year, so unless the Treasury simply decided to default (see an excellent article here by my friends at TF Market Advisors) it isn’t going to happen. The Treasury has made some mystifying statements about how they don’t have the capability to pay some expenses and not others, but in the worst case someone can sit down and manually wire the money to every holder. So that’s nonsense that is meant to scare us.
So I don’t have any decent “trading opinions” on the basis of the government shutdown. What I do believe is that this is an unmitigated positive for inflation (positive in the sense of pushing it higher), and thus for breakevens and inflation swaps. The longer the government stays shut, the longer quantitative easing will be in force as the Fed attempts to counteract the short-term contraction of economic activity (the fact that monetary policy is ineffective at affecting growth rates never seems to enter their minds); furthermore a long shutdown will more likely to push the dollar lower in my opinion – although, as I said above, I can argue the reverse position as well. On the other hand, if the Republicans cave quickly, as is likely in my view, and the ACA goes into effect, prices for consumer-purchased medical care will rise rapidly. This is less a statement about whether the ACA will push aggregate health care costs higher, although I believe that it will. It’s more an observation that controlled prices in the government-purchased sector will produce higher prices outside of the controls, and it is this latter group that will be sampled for consumer prices (since the price the government purchases at is not a “consumer” price). Since it is the Medical Care subgroup of CPI that has been pressing core CPI to be lower than median CPI, any rebound in Medical Care inflation will push aggregate core inflation higher.
Was that said in a confusing-enough manner?
TIPS should do well while the government is shut, because there is ongoing growth in demand for TIPS while the supply will be drying up. Unlike with the nominal Treasury market, there is no corporate inflation-linked bond sector that can replace the inflation exposure (although there should be) demanded by investors, so TIPS will tend to outperform nominal bonds in the event that both sets of auctions are canceled.
 There are other costs, such as the discount to the interest rate that the Treasury pays as a result of the status of Treasuries as superior collateral in repo and similar exchanges, but they are not relevant to this point.
 There may be a practical argument that there might be a substitution effect, but that’s also saying that investors would bet the selloff in Treasuries makes them a better risk-adjusted bet than CAT bonds. However, if the Treasury’s credit spread moved permanently higher, it would not affect the equilibrium bond yield of a corporate bond.
Now, now, children! Stop fighting! This is unbecoming!
It is apparent now that the disagreements in the FOMC – while nothing new – are becoming more significant and the hurly-burly is spilling into the public eye. It is somewhat amazing to me that the Fed is allowing this argument to be conducted in public (traditionally, all remarks by Fed officials are first vetted by the Chairman’s office). Today Dallas Fed President Richard Fisher actually questioned the Fed’s credibility! This article is worth reading, and not just for the part where Fisher says that Yellen is “dead wrong on policy.” It’s also fascinating that Fisher attributed the decision to delay the taper to “a perceived ‘tenderness’” in the housing recovery.
Below is a chart (source: Enduring Investments) of the ratio of median existing home sale prices to median household income. If this is “tenderness” in a recovery, it only shows a lack of knowledge of history: this is the second highest ratio of home prices to income we have since this particular data begins…and the first highest ratio sunk the global economy for a half-decade and counting.
On the other side of the fence were the New York Fed’s Bill Dudley and the Atlanta Fed’s Dennis Lockhart, who lamented that (Dudley) there has been no pickup in the economy’s “forward momentum” and asked (Lockhart) “Is America losing its economic mojo?” These questions, and the result of these questions during the recent FOMC meeting, illustrate two points. First, that the bar for removing never-before-seen levels of monetary accommodation has been raised so high that doves believe it is appropriate to keep the foot on the accelerator until growth is drastically above-average. As I illustrated back at the beginning of August, it is unreasonable to expect more than about 200,000 new jobs per month to be created by the economy. Repairing all of the damage is simply going to take time. We would all love to see 5% growth, but is the Fed’s job really to make sure that happens, or to try and manage the downside (or, as I personally believe, to merely manage the price level)?
The second point that the Fisher/Dudley/Lockhart comments illustrate is that the doves at the Fed are clearly in control. The hawks were completely unable even to get a marginal tapering, although the Fed had clearly indicated previously that such a taper was likely to happen.
It is a Dudley/Bernanke/Yellen Fed (and they have allies too!), and anyone who thinks that the Fed is abruptly going to find religion once CPI peeks above 2% is fighting against all historical indications. One need only consider the fact that the post-FOMC meeting statement pointed out a “tightening of financial conditions observed in recent months,” a clear reference to the rapid rise in interest rates that accompanied the initial talk about tapering. But if the Fed begged off on the taper partly because of the tightening of financial conditions, that is the rise in interest rates that was caused by an expectation that the taper would stop, then the argument circular, isn’t it? It’s impossible for them to stop, since any indication that they were going to stop is obviously going to cause interest rates to rise, which would be a tightening of financial conditions, which would keep them from stopping… Does anyone seriously think that a core inflation print of 2.1% would change that?
To the extent that cutting from 20 cups of coffee per day to 19 cups of coffee per day could be called a “bold step,” wouldn’t the best time to take such a “bold step” with monetary policy be when the equity markets are at their highs and real estate markets back above their long-term value anchors?
And yet, the initial enthusiasm for the stock market for the continuation of QE seems to have faded rapidly. The entire post-FOMC rally that caused such joy around the offices of CNBC last Wednesday has been erased. Interestingly, the initial spike in commodities prices has also been erased, which is more curious since commodities prices don’t depend on growth as much as they do on inflation. And 10-year inflation expectations are back around 2.25%, basically the highest level they have seen since the Q2 swoon (see chart, source Bloomberg). So, as usual, I am flummoxed by the behavior of commodities.
I know that there is a great deal of confidence in some quarters that the Federal Reserve can keep its foot on the gas until such time as inflation actually rises to a level that concerns them. I cannot imagine the reason for such confidence when the drivers of the car are such committed doves. There are multiple problems undermining my confidence in such a possibility. There is the “Wesbury hypothesis” that the Fed will adjust its definition of what worries them about inflation – a hypothesis which, after this month’s FOMC meeting, should be even more compelling. There is the fact that there is no evidence I am aware of that the Fed was able to easily restrain inflation after it came unglued in any prior episode (and no one knows where and when and how it will come unglued). And finally, it isn’t clear to me how the Fed would go about restraining inflation anyway, given the overabundance of excess reserves and the fact that those reserves insulate any inflation process against the tender ministrations of the central bank.
One thing seems to be sure. The food fight at the Fed is not likely to end soon, and together with the dysfunction on Capitol Hill is raises the very real question of whether anything economically helpful is going to be accomplished in Washington DC this year.
Everyone expected markets to provide a lot of late-day volatility today, and so they did. The Fed apparently doesn’t mind surprising the market with a non-consensus outcome when that surprise gooses stocks and bonds higher. Here are some (fairly unstructured) thoughts about today’s declaration from the Fed that there will be no “taper” in its QE program yet:
- This has nothing to do with the fact that there was a minor wiggle in the Employment data, some weakness in Retail Sales, and some other disappointments this month. If that is now the standard…that the Fed plans to expand its balance sheet without bound as long as growth is not smashing the cover off the ball, then we are truly lost for QE will never, ever end. This month’s numbers were all within the normal variation for economic data, which do in fact vary even when the underlying economy is not. The old standard was “ameliorate a deep recession.” Then Greenspan turned that to “resist even a mild recession.” And now, is the standard “robust growth no matter what the long-term cost?” I don’t think so, and so I reject the notion that the failure to begin the taper has anything to do with the growth numbers.
- Similarly, the inflation numbers cannot be the reason. Core inflation is now rising, and the Fed has previously recognized that some of the decline in inflation has been due to transient effects of the sequester. Median inflation has remained steady at 2.1%, which is basically the Fed’s long-term target. The cost of 10-year deflation floors in the market are at the lowest level since they began to trade in 2009 (see chart, source Bloomberg and BGC Partners – the price is in up-front basis points). So it isn’t a lingering fear of deflation that has the Fed concerned.
- The Fed speakers over the last month have had ample opportunity to shoot down the idea that taper would start at this meeting, which has been the consensus for a long time. None of them did so, implying that the Fed was comfortable with that consensus. But something changed in the last few days, and that is that the odds-on next Fed Chairman went from being Larry Summers to being Janet Yellen, who happened to be in the meeting today. Does this change the dynamic? Absolutely, since one reason Bernanke has started thinking and talking about tapering is so as to leave as clean a slate as possible so that the next Chairman wouldn’t have to start his term by tightening (sorry, I mean “reducing accommodation”) and scaring asset markets. Once Summers withdrew his name, Yellen’s vote got automatically much more important and the urgency to start the taper much less (since Yellen doesn’t believe there are any important costs to QE). Indeed, in his post-meeting presser Bernanke noted that the “first step” on a taper is “possible this year.” That is far to the dovish side of what the Street was expecting, but consistent with the notion that Yellen’s opinion will carry a heavy weight unless someone else is appointed to the post.
- Yellen said last June that the Fed’s objective is a quick return to full employment, and that Fed action might be justified “to insure against adverse shocks [emphasis mine],” or even if the Fed concludes that the recovery “is unlikely to proceed at a satisfactory pace.” So, perhaps I need to reconsider my point #1 above. Maybe that is the standard now.
- If in fact QE has no cost, then there is no reason to ever stop it. In fact, it should be accelerated. Most Fed officials seem recently to be coming to the realization that there is highly unlikely to be a costless economic remedy, even if they are not sure what the costs are or think they can be contained. Those people clearly have no voice any more, even though it appeared that those views in the last few months were gaining currency (no pun intended, since the dollar dropped to the lowest level since February after the announcement today – a Fed that was edging however slowly to being more-hawkish than average was good for the dollar; a weak, more-dovish than average central bank will be worse for the dollar all else equal). This is pedal-to-the-metal time.
- TIPS got a lot more expensive today, with the 10-year rallying 20bps to 0.475% and breakevens up 4.5bps one day before the Treasury auctions another slug of them. The auction ought still to go well, because caution has been thrown to the wind by our beloved central bankers. This is also good for commodities, and they rose today led by precious and industrial metals. Is it good for equities? Well…
- Equity analysts are like puppies. They completely forget what happened 5 minutes ago and every experience is brand new. There is never any context. So stocks shot higher today, with the S&P gaining 1.2%, because of the dovish Fed and lower interest rates. But over the last few months, as the taper grew closer and interest rates shot higher, all equities did was move to new highs. So, higher interest rates and a (relatively) hawkish Fed doesn’t hurt stock prices, but lower interest rates and a dovish Fed helps them? This may be why the Fed thinks that buying bonds keeps interest rates low and selling bonds doesn’t raise them. It’s a strange market-based notion of a perpetual motion machine. For goodness’ sake, let’s crank interest rates down 200bps, back up 200bps, down 200bps, and keep doing that and the stock market will be at 1,000,000 before you know it. Prosperity! But in fact it is probably more like a bicycle pump. Pushing down inflates the tire, pulling up doesn’t deflate it. It seems costless. However, if you keep doing that, eventually the tire will pop.
- Speaking of the perpetual motion machine, I enjoyed this little gem from the FOMC statement:
The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction. Taken together, these actions should maintain downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative…
Really? It hasn’t worked recently. Lest they forget: the taper hadn’t started yet, but until today it was busy being discounted in the bond market. I don’t expect that merely continuing to buy bonds into the SOMA will push rates much lower again. We all know that this game ends, and we know how it ends. With 10-year notes at 2.70% I wouldn’t be selling them, but I also wouldn’t expect a massive rally to unfold. I would hold long positions in September and October, because those are the right months in which to hold bonds (especially with debt ceiling fight #2, Syria, Italy’s government disintegrating, and Germany’s election), but if the market gave me 2.45% to sell, I would sell.
 Note, though, that no person who has ever held the office of Fed Vice-Chairman has later been appointed to be Chairman…although Donald Kohn, since he was Vice-Chairman from 2006-2010, would also represent a departure from this same tradition. However, he was not in the room.